Bear Market Rally or New Cyclical Bull Market? Too Soon to Tell

Equity markets ended an otherwise horrible year on a constructive note. Evidence continues to build that the November 20th low marked the bottom of the worst bear market and financial crisis since the 1930s. Global stock indexes have moved 25% or more above their lows amid a slow but steady healing in credit markets and reduction in volatility. Longer term investment grade corporate bond yields have fallen nearly two percentage points in the past month, and the VIX volatility index has finally dropped back below 40 after spending two months in the unprecedented range of 50 to 80.

There were many strong signals that the market was primed for a solid bounce by late November. Historic price declines left the market massively oversold; the policy response from the government was moving into overdrive; and pessimism and fear were at levels not seen since the Depression. After two months of relentless declines, anyone vulnerable to being forced out of the market by price weakness had most likely liquidated.

Now that the acute phase of the financial crisis has passed and the intense risk aversion reflected by a 0.01% 3-month T-bill yield have abated, where do markets go from here? After the largest bear market since 1937-1938, risk assets are the most attractively priced in at least two decades, yet the recession is very bad with no end in sight. No one knows how long the recession will drag on; the answer to that question will likely determine whether markets are now experiencing a bear market rally or the start of a new cyclical bull market. I will be more comfortable with the notion of a new cyclical bull market emerging when the leading economic indicators we track from the Economic Cycle Research Institute turn up, which they have not. However, we should not underestimate the positive effects of lower oil prices and mortgage rates. 30-year conforming mortgage rates have dropped from 6.5% in September to 5.15% today. What is needed now is an improvement in consumer, investor and business confidence, which will go a long way towards breaking the recession dynamics of selfreinforcing contraction in spending, production, employment and income.

Undoubtedly, there will continue to be high volatility in the financial markets, though surely not to the degree of the September to November period, which saw unprecedented average daily swings of 4% in the S&P 500 (SPY). There will be the inevitable selling into rallies, and some of the declines will be severe enough to test the convictions of investors and open up wounds that are just beginning to heal, but overall I expect the November lows to hold and for risk assets to climb the proverbial wall of worry in 2009.

There is certainly plenty of cash to sustain a rally. According to the Leuthold Group, there is currently $8.85 trillion held in cash, bank deposits and money market funds. This sum is equal to 75% of the value of the U.S. stock market, the highest ratio since 1990. By reducing the Fed funds rate nearly to zero, which has pulled money market and CD yields below 2%, the Fed is prodding investors to take more risk with their savings. The combined reflation actions of the Fed and the federal government are likely to be successful in breaking the deflationary spiral in financial markets and the economy, and we hope will not lead to a serious breakdown in the U.S. dollar in 2009.

Comments

[mavericks:]

Do let us know when the "leading economic indicators we track from the Economic Cycle Research Institute turn up."

Jan 06 01:24 PM

[prudentinve...:]

Like other experts, you inform us that ".. there is currently $8.85 trillion held in cash, bank deposits and money market funds..." as a reason to expect stocks to go up as all liquidity surely must pour into stocks.

Perhaps there is a reason this liquidity has not been committed to stocks. Perhaps its owners need it for health care, college, retirement expenses, paying down debt, etc.

Perhaps some of it is waiting to buy stocks at lower prices than today's.

Additionally, when people move from money market funds into stocks, the commercial paper market gets deprived of liquidity. When they move from CD's into stocks the banks have even less to lend, and so on.

Thus, I am not convinced that the exsistence of a significant pool of liquidity necessarily means that the markets are sure to go up in a sustained manner. Economic fundamentals must first improve, and P/E ratios now look very pricey given the projected $42 for E of the S&P500.

Jan 06 02:40 PM

[secmaven:]

Is the bear market over? To ask the question is to answer it. What caused the recession that caused the bear market? A cut back in spending by consumers first, then business. What will make consumers increase spending? Higher wages and a larger number of people being employed. In the foreseeable future can we reasonably predict higher wages and smaller unemployment? No and No.
That is it in a nutshell. The bear market is not over at least not on this planet.

Jan 06 07:34 PM

[Crude Oil T...:]

I believe the primary reason for savings and side line money is going up is peopel pulling out of the market. Some will never return. Some hedge funds are setting up for a new round of "raising cash".

Why do people sell their stock market positions, even when they are under water? It is the only thing they can sell. They can't sell the real estate holdings etc. It is their only option.

Great post!

Jan 07 08:18 AM