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Monday, 3 October 2011

Beware of Market Rallies Ahead

by Kelly Evans

The basketball court won't be the only place for head fakes this season.

Partly because the just-ended third quarter was such a dismal period for stocks, some Wall Streeters now expect a rebound into year-end. To wit: The "mother of all counter-rallies is coming," says Pension Partners strategist Michael Gayed.

And a surprisingly strong reading on Chicago-area manufacturing activity Friday did raise hopes that the U.S. isn't falling off a cliff. The Institute for Supply Management's index of national manufacturing activity, out Monday, is similarly expected to show some stability.

But the recession coast is hardly clear. Yes, Macroeconomic Advisers currently estimates that real gross domestic product rose at a 2.1% annualized rate in the third quarter, after averaging about 0.9% in the first half. But it's the coming months that should have people worried.

On top of the global stock-market rout, precipitous declines in commodities like copper and oil point to a downshift in demand world-wide. And in credit markets—a key leading gauge of economic activity—alarm bells are ringing.

Take the difference between yields on risky junk bonds and top-notch corporate debt. This fell as low as about 1.5 percentage points in February, when investors were chasing risk instead of fleeing from it. Now, as MKM Partners strategist Michael Darda points out, that spread has blown out to 5.1 percentage points. That is still well below the crisis peak of nearly 16 percentage-points, but the speed of the recent increase does echo the start of the upward move in 2008.

The stresses building in credit markets also suggest relatively encouraging signals coming from indicators like weekly jobless claims can't be counted on to last. Warren Buffett may not see a recession looming, but the Economic Cycle Research Institute, a forecasting firm that has called the last three downturns, said in a news release Friday that the U.S. "is indeed tipping into a new recession."

Trouble isn't just confined to the U.S., which helps explain why investors are so jittery. Euro-zone officials have yet to get their arms fully around their debt crisis, while fears of a "hard landing" in China—the world's workhorse —are growing.

Markets never move in a straight line, of course. But investors shouldn't try to hitch their sleigh to any Santa Claus rallies.

Write to Kelly Evans at kelly.evans@wsj.com

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