This Rally Should Have Staying Power

The weight of the evidence suggests that an important intermediate-term bottom was put in on March 6, when banking system insolvency fears peaked, and the S&P 500 plunged to 670, a 13-year low. Apart from the sheer magnitude of the bear market declines in broad stock indexes (60%!) over the past 18 months, which have discounted a tremendous amount of “bad news,” sentiment indicators issued a strong contrary opinion buy signal in early March.

The American Association of Individual Investors survey registered the most bearish reading in its 22-year history a month ago; 70% of respondents were bearish in their 6-month stock market outlook, while only 19% were bullish. The immensity of the government’s stimulus efforts, both fiscal and monetary, which now total a mind-boggling $4 trillion, appear to be taking hold in the economy and markets.

As a percentage of GDP, this figure - which represents the sum of actual and proposed deficit spending and Fed balance sheet expansion to battle the forces of recession and private sector debt deflation - is three times what the U.S. government spent in the 1930s to battle the Great Depression! Inevitably, government stimulus of this magnitude is going to have an effect on asset prices and economic activity.

In addition to the firming that has occurred in stock and commodity prices, evidence has emerged that the economy is stabilizing. According to the latest leading economic indicators from the Economic Cycle Research Institute, the pace of economic contraction will ease in the coming months, implying that we are getting through the worst part of the recession. Even the most adverse periods in economic and financial market history (e.g. the 1930s and 1970s) have intervals of reprieve, accompanied by multi-month rallies in risk assets.

Our sense is that we have entered such a period, and that this rally will have significantly more staying power than the respite from the selling that occurred at the end of 2008. Stocks are quite overbought in the short term, however, so markets will likely spend several weeks consolidating or correcting recent moves. Now would be a natural time for such a consolidation or correction to begin, given that the 26% gain we have seen over the past four weeks in the S&P 500 almost precisely matched the 27% rally in the S&P 500 from November 21 to January 6. A reasonable technical and fundamental price objective for the S&P 500 over the course of a multi-month advance is 950 to 1000.

Stocks, both in the U.S. and abroad, are very cheap from a historical perspective, but the economic problems are daunting. This argues for a neutral (and patient) allocation to stocks in a longer term asset allocation context.

The economy seems to be in the process of stabilizing from the free-fall that began last September, and will likely spend an extended period at approximately the current level of economic activity, propped up by massive government intervention and stimulus, and simultaneously weighed down by private sector balance sheet rehabilitation, which will involve a multi-year process of higher savings and debt reduction.

There is a strong case to be made for a healthy allocation to foreign stocks in an equity portfolio: they are cheaper than U.S stocks; key emerging markets (e.g. China and Brazil) have superior growth prospects; a number of foreign economies (both developed and emerging) have fewer problems with banking and debt; finally, there are reasons to be concerned about the U.S. dollar over a secular time frame.

Comments

[altaman:]

A sucker's article for a suckers' rally. Givemeabreak!!!! The global economic is tanking and there is no way that the reality of what is coming has been priced into the market - hyper taxation, hyper inflation, hyper government interference, hyper government spending, etc.

Apr 16 02:37 PM

[Bartlesby:]

J.D. - what is your basis for saying that "Stocks, both in the U.S. and abroad, are very cheap from a historical perspective"? Using Price/Book values during a period of massive asset devaluation seems rather questionable.

The forward 12-month estimate for the S&P500 As-Reported Earnings is currently $28.51. At today's 870 index level that puts the S&P's forward P/E at almost 31. Compare this to the historical average of 15.8 and we are nearly twice as expensive as historical "fair value."

(The S&P earnings history and estimates are available at www2.standardandpoors....).

Many bullish arguments today employ Operating Earnings rather than As-Reported Earnings, which grossly understates the earnings multiple. At the current multiple of nearly 31, a cautious approach is most prudent.

Apr 16 03:51 PM

[Yamaka:]

I like the article and the conclusion.

1. Historically, the broad market (SP500) was trading at 3.5 X book value ($530). This means SP500 needs to be near 1855.

2. The broad market used to be 1.5 X of 1 oz of gold. This means SP500 needs to be near 1335.

3. The expected SP 500 earnings for 2009 is about $60 (as per Briyni, as reported in WSJ Market Data). When the 10 yr T is yielding under 3%, an earnings yld of 5% (P/E multiple of 20) is very reasonable. This means SP500 needs to be near 1200.

All this suggests strongly that the market will close near at least 1100 (SP 500 Index) by the end of this year, and 1300 in 2010.

When will we cross SP500 Index 1500? Probably, by the end of 2012. This means we lost nearly 4 years because of this deep recession. That's very sad.

Cheers.

Apr 16 04:55 PM

[Paws off My...:]

hah.

hah.


hah.


...hah!!!!

Apr 16 06:31 PM

[jkerviel:]

If there were a significant number of buyers (yes, they are important) would the market manipulators need to play tricks with leaked memos and 2 week early earning announcements , etc. ? This analysis of P/E ratios and historical earnings is meaningless when a large number of people won't touch stocks , even if the Fed is determined to force them in.

Apr 16 06:42 PM

[Stone Fox C...:]

It will be interesting to see where SP500 earnings turn out for 2009 now that we've got banks blowing away estimates. When a firm like RF goes from a expected $.42 loss to a profit, the estimated earnings will be much different then everybody thought.

Apr 16 06:52 PM

[Rick Urban:]

This is good article. The recovery is on its way. It is interesting to watch doomsayers panicking and loosing big money at the same time. There will be more bad news coming and market pull back. However, most of the bad news is priced in the market. Remember March lows. The market trend will be upward. It is still time to invest in good companies ( there are many). Do your homework and you will make good money in the next 2-3 years. Forget the doom and gloom.

Apr 16 06:56 PM

[Alan Young:]

Agnostic, here.
People insist that they are sure the market will be one direction or another. If that's all you have to contribute--gimme a break. She's not called "the great humiliator" for nothing.
The only smart thing to do is stay balanced, and be ready to jump either way.

Apr 16 08:52 PM

[William Cowie:]

Good article, if one keeps in mind the recovery is only beginning. Recovery in the stock market, that is, not the economy as a whole. The stock market always looks ahead, we all know that. But this particular market is being stimulated by the Federal Government to a degree never seen in human history.

However, and there is a however, we should expect the transition from the market to the economy to take longer than before, for two reasons:

1. Consumers are undergoing a value shift toward less consumption, not totally unlike what happened after the Great Depression. This means a major engine for growth is being shut off, and there's little anybody can do about it. (If I don't want to buy a Harley I don't need, I don't care how low your interest rate is.)

2. Uncle Sam is so fixated on helping his buddies on Wall Street that he's not hustling to do the only other thing to get the economy moving: infrastructure spending. Now is the time to get all those bridges built, highways updated, high speed rail lines put in, and anything else that puts people to work..

There is another problem which can still derail the recovery completely: the major destruction of wealth in the commercial real estate market. The bankruptcy today of General Growth is but the first publicly visible manifestation, but all those closed retail outlets are only beginning to show the damage to the malls, which were overbuilt even before the recession started.

In summary, yes, the stock market recovery seems to have crossed the point of no return (except of course for the usual pullbacks), but only because of the Obama dollars pumping it up. The economy? No such luck there anytime soon...

.

Apr 16 09:21 PM

[E Nuff Sed:]

The S&P on a trailing basis is trading at a trailing (TTM) PE of 12.66 and forward estimate of 14.63. Last time the market was this cheap on a PE basis was in Q3 - 1990. That is if you believe the estimates.

Apr 16 10:22 PM

[jeandit75:]

Its impressive how hope can be contagious. Don't you find it weird that people are starting to invest again as though there were no risks. This is getting crazy. I am not going to say that markets are being manipulated but just take a look at the recent economical figures. They are systematically being reported above forecast so that investors can cheer the so-called "second derivative" improvement but what they are not speaking about is the last month figure downward revisions. Just take a look on you the far right column of the Bloomberg ECO page and you'll understand. The Shawshank redemption was a great movie about hope. I also think hope is a good thing but please, stop dreaming. This market is due for a severe correction cause there is no "second derivative" improvement in the economy and investors are getting complacent with the market upward movement. Anyway, good luck everybody.

Apr 17 02:13 AM

[jeandit75:]

...and oh, please Jerome, don't have us lose another $5 billion


On Apr 16 06:42 PM jkerviel wrote:

> If there were a significant number of buyers (yes, they are important)
> would the market manipulators need to play tricks with leaked memos
> and 2 week early earning announcements , etc. ? This analysis of
> P/E ratios and historical earnings is meaningless when a large number
> of people won't touch stocks , even if the Fed is determined to force
> them in.

Apr 17 05:43 AM

[InvestBaboo:]

So we all agree that if we sat down and had a few beers and shared real life misery we have witnessed due to the tanking economy we would probably decide to go sell everything we own, buy shotguns, live out in the mountains and wait for civilization to end, correct? Yet we look a the markets that have staged a tremendous comeback and we look at each other in surprise and shake our head in disbelief. Many of us will go hang around with the same friends, drink more beer, tell more sad stories and become convinced that the markets will fall any day soon and it could be tomorrow and yet the marker continues to go up and up. Finally the day comes when we can take it no more and we plunge into the market only to watch it fall and find the label Bagholder tattoed on our forehead!

This is the problem when we try use our intellect, analyze the world events and speculate which way the market is going or not going. We are wrong a majority of the time. Peter Lynch said go find a product you love and buy the company and I found that I was right only 1 out of 100 times and the rest of the times there was information that I had no access to as the equity mysteriously started heading south and wipe out my capital before I could act from my frozen state of disbelief. So now I don't try to understand why the market is moving the way it is moving. I just follow it. The market says it is going north - I go long on equities. Like most of you I find it much easier to be a bull than a bear so if the market is going south I stay out of it. I no longer care what equities I own -- only that they show good readings on the chart and when they stop doing so I am out of them. Give this a try -- you will be amazed how handsome your returns are when you ignore the world and focus purely on the metrics.

Welcome to the Matrix!

Apr 18 04:52 AM