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posted on 08 March 2016

What To Expect From This Bear Market Rally

by Michael E. Lewitt

Money Morning Article of the Week

Stocks rallied for the third straight week in what appears to be a classic bear market rally. Investors should count their good luck and use higher prices as an opportunity to reduce equity exposure or hedge stocks they don't want to sell.

Last week the Dow Jones Industrial Average jumped by 367 points or 2.2% to 17,006.77 while the S&P 500 rose by 52 points or 2.7% to 1999.99. The Nasdaq Composite Index rose 2.8% to 4717.02. The major averages have gained about 10% since their February lows, giving investors hope that the worst is over.

I do not believe it is. Despite some moderately positive economic news last week, the global economy remains depressed and the prospects for significantly higher stock prices are low. Let me explain.

Markets were encouraged by what they interpreted as strong economic data as well as signs that the oil price decline may be over. Friday's jobs report, which was weaker than it looked, convinced them that the U.S. is unlikely to fall into recession this year. Earlier in the week, manufacturing data was modestly better than expected. And most important, oil prices rose sharply last week, teasing the end of the energy collapse.

The Fed will Turn Good News into Bad News Again

Let's assume for the sake of argument that they are correct about all of these factors. The problem with such a scenario is that, with a 4.9% unemployment rate and inflation ticking up toward its 2% target, the Federal Reserve is under increasing pressure to raise interest rates. Weak markets gave the Fed an excuse to delay doing so.

But a combination of better economic data and stable/rising markets makes it more likely that the Fed will increase interest rates sooner rather than later. They are unlikely to move this month but the odds of a June hike are increasing. And as we saw after the Fed raised rates in December, markets do not react well to such moves.

Higher rates would mean a stronger dollar, which would place downward pressure on oil prices and corporate earnings in the U.S. The corporate credit markets have already raised the cost of capital for both investment grade and junk bond borrowers, which will further depress corporate earnings.

In other words, the good news that investors celebrated last week could very quickly turn into bad news. And if investors are wrong and the economy is not all that strong (which is what I believe), they are jumping the gun. Either way, stocks look very risky here and investors should proceed accordingly.

The One Stock to Avoid at All Costs

While many stocks regained some of their early 2016 losses over the last three weeks, one stock that has not is Valeant Pharmaceutical International Inc. (NYSE: VRX). In fact, the VRX story keeps getting uglier and uglier and is reflected in the stock reaching new lows this week before closing at $61.31 per share, down from $80.65 a week before.

The stock collapsed (again) this week after the company made a series of announcements - the return of its CEO J. Michael Pearson from a medical leave, the withdrawal of its 2016 earnings guidance and the departure of another key executive responsible for overseeing two of the company's most important drugs.

It also disclosed a new SEC investigation into its relationship with defunct mail order pharmacy Philidor RX Services. Analysts are questioning with good reason the company's ability to service its $31 billion debt load, a concern that was bolstered by Moody's Investors Service placing the debt on watch for a downgrade.

Anyone looking for good news at VRX is looking in the wrong place. A company built on a toxic combination of debt, drug price hikes, low R&D and a refusal to tell investors the truth is now paying the price. Investors should avoid this stock at all costs.

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