Monday, April 20, 2009

Reversible Rally?

Some more invigorating early am thoughts from David Rosenberg on the fate of the rally.

Either way, the test is the key.

We are witnessing a reflexive rebound, in our view What we are going to do today is provide some perspective on this impressive rally over the past five weeks. In our view, what we are witnessing, at best, is the famed reflexive rebound that occurs between the down-legs of the secular bear market, as so eloquently referenced in Rule #8 of Bob Farrell’s Market Rules to Remember (it goes like this – “Bear markets have three phases: sharp down, reflexive rebound, and a long fundamental drawn-out decline”). By “reflexive rebound” what is meant is a real bear market rally that can last between four to eight months and have the capacity to rebound between 25% and 50%, as opposed to the countless flashy but not particularly tradable rallies that typically last four to eight weeks and post a 10% to 20% bounce.

The test remains the most appropriate near-term focus

So, the question is whether this is just a more intense version of the other spasms we saw this cycle or something a little more durable like we had between September 2001 and January 2002, when the Nasdaq surged 45%, but was retesting the lows by June 2002 (and the test failed, as we know with hindsight), or perhaps something along the lines of the 43% bounce in the S&P 500 from 98 in March 1980 to 140 in November 1980. That low was tested by August 1982, as we went through the ‘drawn out fundamental downtrend’, and, in this case, the test was successful. But we had the retest nonetheless, and we think we have to be reminded that the test remains the most appropriate focus over the near term.

Reflexive rebound vs. flashy bear market rally

What makes the reflexive rebound different than a flashy bear market rally is that it’s not just short-covering and other buying on the part of the ‘pros’, but real money sitting on the sidelines that is put to work. This is why the reflexive rebound tends have more staying power. This is really a debate best left to the technical analysts, but for our two cents worth, history tells us that we have to be cognizant of the re-test possibility. With the market up 28% and 85% of the stocks trading above their 200-day moving averages, the inevitable test is something we should spend more time thinking about than trying to chase the last leg of this rally, assuming it comes at all.

Durable bull markets need macroeconomic inflection point

No durable bull market has ever occurred without their being a macroeconomic inflection point within reasonable proximity of the market low. For example: the national highway network in the 1950s, the space program in the ‘60s, and the spectacular household formation of the baby boomers and consumer balance sheet expansion that sharply bolstered domestic demand in mid-‘70s. The post-1982 bull market was driven by massive reductions in top marginal tax rates, deregulation and declining unionization rates. The 1990s was led by tech induced productivity gains and rapidly diminishing fiscal deficits; and the last bull cycle from 2003 to 2007 was a function of leverage and a speculative debt-fueled plunge into residential real estate – ill-timed as it turned out.

What we have to look forward to

This time, as we gaze into the crystal ball, what we have to look forward to for the foreseeable future is an unprecedented incursion of government in the economy and capital markets, a much more regulated financial system, where the contribution of credit to spending, output, employment and profits will be far lower than has been the case for the past two decades, higher environmental-related costs, less free trade, rising union membership, and higher marginal tax rates to pay for the fiscal mess we’re in. Most importantly, what we are looking at is a secular contraction in the household balance sheet as it relates to the baby boomer cohort – secular meaning many years. Keep in mind that it is this 78 million US boomer population that has been the critical driver of global economic activity, not to mention the pace-setter for consumer spending behavior – or lack thereof as the pendulum swings toward frugality.

Economic underpinnings not in place for a true bottom

Unless emerging markets in general or China in particular, can manage to pull the developed world out its torpor, it is difficult to identify what the next macroeconomic underpinning is going to be that will generate a sustained bull market in equities. Sorry, but government sector expansion, hybrid cars, green technology and digitized medical records just don’t do it for us. While we are willing to keep an open mind over the possibility that this reflexive rebound could have more legs, we simply do not have the economic underpinnings in place for a true fundamental bottom, which is why we think, like Japan, the dominant theme will be the third part of Bob Farrell’s’ Rule #8, which is the drawn-out fundamental downtrend to the true low.

It’s only the bottom of the fourth inning

To finish up, we have an old saying that, “when in doubt, use someone else’s research” and with that in mind, we point to a brilliant report by Ken Rogoff and Carmen Reinhart published late last year. This epic report examined 15 other credit contractions and asset deflations in the past, and found that the bear markets in equities last an average of 3-1/2 years, with the bear market in house prices lasting an average of roughly six years. So, when asked “what inning are we in?”, the answer we’ve been giving, on this basis, is “the bottom of the fourth”.

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