The US market has been down for almost two weeks, resulting in lows not seen since May while the Straits Times Index (STI), still trading above 2,200 points, has taken its cue from the US market and has been down some 200 points off its high of 2,424 points.

While US and local economic data have been encouraging, investors are no longer willing to accept better-than-expected but still contracting data.

The stock markets have risen some 40% to 50% since March and concerns about valuations have started to creep in, and stocks no longer look cheap compared to three months ago. In fact, valuations have reached levels not seen since last September which coincides with the peak of the crisis when the US economy neared collapse if not for the huge stimulus package initiated by the US government.

However, if valuations are at levels of September 2008, then it should not look too stretched because earnings in the fourth quarter of last year and the first quarter of this year have not been too bad. Most of the earnings have been better-than-expected and soon-to-be-announced earnings starting from the first week of July should give a further boost to stock prices if they were to surprise on the upside, especially after an almost 10% correction in stock markets within a one-month horizon.

Conflicting Comments Confuse Investors
We have heard the bullish comments posted by the US government as well as the rosy outlook painted by Chinese Premier Wen Jiabao who said that China’s economy is on the path to a firm recovery. Together with better-than-expected jobs data that pointed to lower continuing jobless claims in the US, stock markets in Asia rallied in the morning of 23 June only to be denied by a World Bank report that claimed the global economy may be in for a deeper recession this year.

This is not the first time the markets have been shocked by such conflicting reports from the world bodies. Some time ago, the Fed Beige Book had the same effect on global markets when it contradicted remarks made by President Obama and Treasury Secretary Timothy Geithner. The Beige Book warned that the US economy is unlikely to recover soon while Obama and Geithner have been posting bullish comments on the economy.

The last time global markets fell on conflicting remarks, it fell and soon recovered to rally strongly. Now that global stock markets have corrected to acceptable levels, it is likely that another rally will soon take place especially if the Fed meeting on 24 June manages to please the market.

Minor Setback Amid Bullish Environment
On the back of an environment that has produced some encouraging economic data but with stock markets pulling back, it is likely that the current correction is healthy in nature. Although the pullback may last for a while, it certainly does not threaten the uptrend.

Meanwhile, the Dow Jones Industrial Average (DJIA) has been trading range-bound (8,200 to 8,900) for the last two months with a break on either side seen as meaningful. If the DJIA were to go below 8,200 in the coming days, then the next support can be seen at 7,800 but that is not likely unless bad news overwhelm the market.

As for the STI, it has corrected some 10% off its high of 2,424 and strong support can be found at 2,180 followed by 2,100. In the short-term, markets look slightly oversold and, thus, a relief rally can be expected but it is more important to watch the news flow that follows because that will determine the trend in the medium term.

If the indices can rally and hold on firmly to gains in the first week of July, more gains can be expected to come.

Most importantly, the jobless data and the earnings set to be announced will be of paramount importance because investors are now looking beyond less-negative figures and will be encouraged by more good news relating to growth.

Financials And Commodities To Benefit
We have seen how the financial stocks have battered the stock markets. Financial stocks represent the health of the economy and the US government has done the most to remedy the damage caused by these companies. Unless there is another sector that can replace this group of bellwether, financial stocks are expected to lead the rally once again.

The share prices of DBS, UOB and OCBC have rallied strongly but are taking a breather, presenting investors with a chance to buy on the cheap. We have heard of local investors buying into shares of Bank of America and Citigroup, largely due to potentially huge gains, but some are shunning local banks due to a lack of confidence in the market. If investors are buying into shares of foreign banks, shouldn’t that translate into confidence in the banking sector? For less sophisticated investors, local banks are the best proxy in riding a rally.

Once again, investors should look at shares of DBS because it has always managed to outperform other local banks in a rally. The government-linked bank has seldom traded below the price of UOB, which means that it will sooner or later catch up with UOB in terms of share price on grounds that its future asset quality will improve as well as its exposure to the China market via Hong Kong.

If the market is questioning the commodity rally, then it should also present investors with a buying opportunity because doubts often push down the share price. With China as the main buyer of commodities, the rally will be fueled by buying from other markets once the economy recovers. For now, China’s stimulus package will continue to boost demand for commodities especially metals and coal because of huge infrastructure development.

Volatility To Continue
We can expect more volatility to continue as long as investors continue to doubt the rally. But once the stock markets start to rally on the emergence of further good news, doubters will be converted and this is the time where short-covering and buying will push the markets higher.

At the moment, we can only rely on the policy statements made by the Fed on 24 June to give us a short-term direction. For medium to long term, the recovery theme must be backed by improvement in the jobs and consumer-related areas.

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