We’ve gotten a little ahead of ourselves.
Readers know that I’ve been suspicious of this stock market rally for some time now. To my way of thinking, stocks can go any which way they please, but at some point reality (in the form of fundamentals) takes hold. The problem is that it can take a long time for that to happen.
Let’s rewind to 2008 for a moment. At the beginning of that year, Barron’s interviewed 12 Wall Street strategists. ALL of them thought stocks would rise in 2008. The average forecast was a 10% gain. And yet, at the time of that survey, the following information was publicly available to anyone who spent time looking at income statements, balance sheets, and cash flow statements (AKA actually doing research):
- Every investment bank was insolvent with Level 3 Assets (based on imaginary accounting models) far in excess of their equity.
- Most large banks were insolvent or close to it due to their owning trillions (with a T) in derivatives (at that level even 1% of bad bets mean the bank is done).
- Fannie Mae (FNM) and Freddie Mac (FRE) were virtually insolvent due to their being leveraged at 100 to 1 and requiring rising home prices to stay afloat
Put another way, the entire financial sector was virtually dead on its feet. And yet, it took 10 months before stocks truly collapsed under the weight of these issues. To me, that is absolutely extraordinary. And it indicates the degree to which the market can operate under delusion before the underlying economic realities take hold.
Now let’s look at these same issues today.
The investment banks are all gone (except Goldman Sachs (GS)), having been swallowed up by larger financial entities. But were the Level 3 assets that plagued these guys ever accurately priced so the market could rest easy knowing their real value? Nope. They were buried in the larger banks balance sheets OR pawned off onto the Federal Reserve.
And have the larger banks gotten their balance sheets in order? Nope. Several of them (Bank of America (BAC) in particular) are now finding out that the smaller players they gobbled up came with some serious financial baggage. Oh, and they still own trillions in derivatives.
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What about Fannie and Freddie? Surely the $400+ billion we’ve spent got them back on track? Nope. Housing starts year over year are showing their largest drop since the post-WWII shutdown. And home values continue to plummet. Collectively Fannie and Freddie owned at least $1 trillion sub prime mortgages… so expect the Government to be funneling more money their way too.
I realize I’m going the long way around the barn on this essay, but my main point is that NONE of the main issues plaguing the financial system have been addressed (there are MANY more issues, but I’m focusing on these three today).
So, to me, this is clearly a bear market rally because the fundamental picture has not changed. Now, bear market rallies have three key features. They are:
- Dramatic jumps you don’t see during bull markets
- Role reversals in which the formerly worst sectors outperform
- Dominated by or heavily involving short covering
This current rally follows all three to a “t.” Stocks are up 40%+ in a few months. That doesn’t happen during bull markets. Bull markets typically see more gradual (and sustainable growth).
Similarly, a bull market typically shows broad growth across multiple sectors. This rally has been dominated by the former losers from the downturn (financials and retail). Indeed, these two have accounted for 50% of the market gains through the end of April. We haven’t seen the growth broaden across other sectors either.
Finally, much of the fuel for this rally came from short-covering. Zero Hedge reports that during the first two weeks in May, over 300 million shorts were covered in the Russell 3000 alone. Financials alone saw $2.9 billion in short-covering. As you know, short-covering means buying stocks, which means higher stock values.
On top of all this, stocks have already discounted three years of recovery. According to David Rosenberg (formerly of Merrill Lynch, now chief economist at Gluskin Sheff), the S&P 500 is now priced at operating earnings per share of $75. Put another way, the market is currently trading as though it had priced in the recovery of the next three years (assuming that the economy bottoms in September as the current consensus believes).
Moreover, from a value perspective, the S&P 500 is currently trading at 33 times 2009 expected earnings (931/ $28 =33 ). So it’s hard to make a case for value at this level. And bear in mind that earnings are heavily overstated due to various accounting gimmicks; real profits (cash flow) are likely even lower, pushing the P/E even higher.
So, could the stock rally continue? Possibly. A lot of retail investors are lamenting having not gotten in earlier. They could well pile in now and push stocks even higher.
However, I don’t see it. The market has come close to breaking down several times. Volume is dwindling to a trickle. Every time someone’s stepped in with a large purchase of stock futures, causing a reversal. But this cannot continue forever. Granted it may taken 10 months (just like in 2008), but at some point, the great rally of 2009 will end. When it does, it will be quite ugly.
Good Investing!
