Schizophrenic Market Rally, Bear Attacks and Inflation

As readers of my blog and followers of my Newsletter know, I am no fan of this rally. I feel it will soon come to a bad end. This, though, has not kept the Newsletter from being 60% invested, as I write.

In times like these, the ever lurking schizophrenia comes to the fore. The market is schizophrenic in both senses of the word: it seems to have lost contact with the economy, and it manifests the usual contradictory bipolar behavior.

Perhaps not surprisingly, the market forces its nature onto investors and traders so that they, too, become schizophrenic (not necessarily medically so). Take my statement, that I don’t like the rally but am 60% invested. That's definitely bipolar. After all, what can be more schizophrenic than demand and supply at the same price?

It helps that many of us have to test trading systems continually, thus coming face to face with that messy process called the scientific method. The Method is itself schizophrenic – first keep an open mind and try and find relationships between data series; then, when you think you’ve seen something, subject it to rigorous statistical testing and try to disprove it. So traders are surrounded by bipolarity all the time and had better get used to it.

As to the current state of play, there seem to me to be too many bulls too soon.

SPY closed at $68.11 on March 9^th and is $91.41 as I wrote this, up 34%, in just two months.

My main concern is that the market is moving up (1) too rapidly, (2) on news which is merely good and that only if compared to what came before, (3) our metrics are shaky, (4) we are reading too much into the metrics, and (4) too many people have a stake in the financial and housing sectors, all desirous of sucking in good new money.

Shaky metrics? Like what’s the P/E ratio of the S&P 500? (See, for example, Prof Jeremy Siegel’s debate on how best to calculate a P/E ratio for the index.)

Reading too much into them? Like, in such turbulence, how can we trust bank accounting? And what are profits if, at the same time, they need a “capital buffer”?

Bear Attacks

I am not a value investor but having started out studying the fundamentals, I still follow value investors closely because I cannot overcome the discipline’s appeal.

At Ivey School of Business, they set up The Ben Graham Centre for Value Investing and on the website posted interviews and lectures by leading value investors including Warren Buffett, Walter Schloss, Seth Klarman and others.

One of the contributors is Kim Shannon of Sionna Investment Managers here in Toronto and she discusses, in the second half of her lecture, what happened in previous bear markets to P/E ratios after each successive bear attack and how, eventually, markets ended up at single digit P/Es.

Single digit P/E and an average sustainable dividend yield of more than 5% or 6% is the solid ground the bull needs to gain traction. Otherwise, unless there are major developments, the ground is too mushy.

Inflation/Deflation

Many of the more erudite economists I have followed recently believe that deflation is a greater danger than inflation, principally due to excess capacity and the sluggish velocity of money induced by deleveraging.

The market, on the other hand, seems to be thinking of all the newly created money seeking a place. Many advisers speak of the huge amounts in money funds, ready to spill into equities and commodities.

I used to think that inflation is unlikely to be a threat for some time. Now, I am having second thoughts:

As I said, SPY increased 34% in two months. XLB, the basic materials sector, is anticipating much improved profitability since it is up 44%. During this same period of time, since March 9^th, light crude oil increased by 20%. DBC, the DB Commodity Tracking Index Fund, is up 11%.

I don’t want to read too much into these price movements, but I am a little surprised at how quick commodity prices reacted to the perceived good times. Maybe it is going to be inflation after all.

Note: inflation is good for commodities, but not necessarily good for equities. See Warren Buffett’s "How Inflation Swindles the Equity Investor”, which appeared in Fortune in 1977.

DISCLOSURE: I have a long position in XLB. No position in SPY, DBC.

Comments

[herbert hoover:]

Inflation is a non-issue. Deflation is still what the fed is desperately tring to fight. Assets are still falling (real estate) demand is falling and the latest job report now says pay per hous is falling. Deflation is the real enemy. Hold lots of cash

May 08 09:17 AM

[winindthedust:]

Your Puts are my opportunity. The rally will continue, there is plenty of upside with summer coming.

May 08 09:41 AM

[winindthedust:]

Further, if we're talking about the market's "mental health", I would argue that most investors are tired of being depressed. They are tired of being on the side lines. They DO NOT want to miss market recovery. It's more risky to stay out, at this time, then sit on the sidelines. They want to recover last years losses, and they want it now. These are bulls chomping at the bit and pulling forward. How's that for a focused state of mind? It's the bears that continue a schizophrenic, second guessing, wishy-washy indecisive mood. This lack of discipline will only help the bulls rally higher.

May 08 09:48 AM

[altaman:]

Deflation fears are greatly overblown and have been used to justify extraordinary wealth and risk transfers by fiat. Unwinding of grossly overpriced assets, floated an a sea of cheap paper, is that not that deflationary IMHO as they are a limited asset class.

The inflation that is showing up in commodities is largely the result of the relentless debasement of the dollar and a general, unlocalized fear of what shoes are yet to drop. Perhaps some of it is an anticipation of an upturn in the US economy but that is largely speculation as there is no real evidence of that upturn todate.

May 08 04:39 PM

[Lee 99:]

comparing an inexact 'science' psychology to an inexact reality, the market, probably makes sense. Or did I forget to take my lithium?

May 08 10:35 PM

[Erick Tippett:]

Expecting to regain all of which they have lost over the last year
wil be the undoing of those who hungrily re-enter this market.
This rally has not the underlying economic support to last that
long!

EDT
Chicago, Illinois

May 08 11:43 PM

[bartpr:]

you are ignoring or not aware of the market recovery from 1933 through 1937. it went up a collective 100%+. as soon as fdr got into office in 1933 the deal was initiated. fast forward to 2009 and the new deal. of the administration. is it any quetion why the market is going up. the bears are out of touch with history. too bad.

May 09 12:29 PM