Market Confounds Bears, But Are Green Shoots a Mirage?

The market continues to confound the bears. Not only is is climbing a wall of worry, it's ascending as it tramples the backs and steps on the heads of incredulous investment professionals. After all, has anyone REALLY seen any verifiable shoots, seeds, or flowers? Anyone other than Larry Kudlow, that is. First he saw Goldilocks carrying the stock market in her basket ever upwards just as she tra-la-la-ed right off a cliff. I often wonder if the shoots and seeds that fuel Larry's persistent optimism reside under gro-lites in the back room of his basement.

From an economic standpoint, the best news we can get these days is that the 2nd derivative of economic implosion is decreasing. That is, things are still awful and getting worse, they just aren't getting worse as quickly as they were. Personally I, like many others, feel that this rally is underpinned by vapor. The only thing I can see that "should" be driving a rally is that the silly-cheap levels some stocks attained in early March lit a fire under value investors. For a few days anyway.

I have been trimming fully valued holdings selectively. Most managers however are wrestling with regret that they didn't invest enough in early March, and wondering whether they should jump in now. I have heard the long-bearish Jeremy Grantham among others express this sentiment recently. Yes, I was buying in early March, but not nearly enough. It turned so quickly that I sat on my hands waiting for a reversal that never came. Luckily I was pretty fully invested, but in hindsight everyone should've gone all in.

So we are presented with a still very questionable economic environment and a market that is way up from its recent lows, yet is probably no more rich than fair-valued (short of another leg down in the economy). What to do? Personally, I keep looking for individual bargains, but my valuation criteria is far more strict than it was in the past. I have a hard time forgetting how cheap many of the stocks I am looking at were only weeks ago. So I wait to buy, and look to trim. In fact, if anything will prevent a lower low it's all the value guys praying they can buy in again at early-March prices.

Can this rally continue even in the face of a continually bad or even worsening worldwide economy? Paul Castro detailed several bullish technical indicators in this interesting article. Lots of money on the sidelines, earning el-zippo. Under-invested mutual fund managers. Powerful looking upward trends. And the Coppock indicator turning. This morning,the long-bearish (and until recently dead-on) strategist for SocGen, Albert Edwards, also detailed the turn in the Coppock. You can read about this indicator here and see the chart. It has been very reliable in gauging long-term market turns in the past. Edwards appears to respect the Coppock's record, calling it "one of the most reliable technical indicators". Yet he is sticking to his bearish bent, citing declining truck and railway tonnage.

Even Grantham, frequently described as a perma-bear (other than in late Feb / early March) has conceded that this rally could become "Son of Credit Bubble". In a recent letter to his clients he says that "the greatest monetary and fiscal stimulus by far in US history" sprinkled with a "super colossal dose of moral hazard" could generate a market rally "far in excess of anything justifed by... economic fundamentals".

Some would say that this has already happened. James Montier, the other SocGen strategist and a deep-value and behavioral finance stalwart, cites Grantham and then sets out to explain how this can possibly happen. It's the liquidity shock, stupid! Or should I say the "stupid liquidity shock"?

Montier details an experimental market study (conducted by Vernon Smith using simulated markets) that shows that although trading experience lowers the propensity to form bubbles, it's not failsafe. In these simulations where subjects trade equity-like instruments, they invariably form a giant bubble the first time they "play". Interestingly, they do it again the second time. In this case participants explain that they all thought they could get out before the crash - overconfidence rears its ugly head. The third time, however, pricing closely follows fundamentals. UNLESS there is a liquidity shock. The investigators doubled starting capital and halved equity shares outstanding, and voila, bubble #3. Even though #3 is not as extreme as its forefathers, equity prices still reach 2x fundamental value.

Now you can argue all day whether such experiments apply to the real world. But this series does seem oddly familiar: tech bubble, credit bubble, son of credit bubble 2009? Montier confesses that he (and certainly then I too) has no idea if the stimulus actions to date are shocking enough to reflate a bubble. Clearly Grantham thinks they might be.

Comments

[Chandragupta:]

Good article. You are right!

Jun 04 02:10 PM

[thiazole:]

If you wait until the recession ends to invest, you'll miss the majority of the gains. Check out an S&P chart were the recessions are shaded. I can only think of one example (2001-2002) where the stock market didn't hit bottom months before the recession ended. The stock market almost always climbs the most while still in recession, but when the 2nd derivative is improving. I don't know why people are acting like this is a new phenomenon...

Jun 04 04:32 PM

[stockferret:]

At least I'm not the only one. When I sold half my holdings a month ago after an almost 75% two month gain I felt pretty good. Until those stocks continued up another 41% from where I sold them.

I would like to think I can preserve my capital with some tight mentals stops (broker won't allow trailing stops on the kinds of stocks I tend to own) but, hey, I have a real job to work at too. And besides, when this market (or GS) decides to stop playing this game it will probably gap lower >5% and then continue to disintegrate before us little guys return from getting our morning coffee.

Jun 04 06:05 PM

[VP of Commo...:]

Why oh why do all the bears use the fundamental assumption that the market was fairly valued on March 7th when they do an analysis?

Jun 04 07:08 PM

[Larry House:]

I agree with Doug Kass that I am not a bear or a bull. I don't think the market was fully valued in March. The market overshot as it always does. On the other hand, based on fundamentals, just how much higher (if any) is justified? We may be starting on another bubble. I just think this is a time that requires nimbleness and caution. The market can and does go down and quickly as it goes up. There is still a feeling with many, and I am one too, who think we have not yet seen the worst of the economic downturn. That does not mean we haven't seen the lows in the market, but there are a lot of ghosts out there not accounted for.

Jun 04 11:38 PM

[thiazole:]

If you look back to posts from that time, most of the bears here were saying the market would fall much more even at the bottom. It was irrational pessimism at its finest.


On Jun 04 07:08 PM VP of Common Sense wrote:

> Why oh why do all the bears use the fundamental assumption that the
> market was fairly valued on March 7th when they do an analysis?

Jun 05 12:12 AM