This Rally Smells Fishy to Me

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.

Click to enlarge:

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:

1. Dramatic jumps you don’t see during bull markets
2. Role reversals in which the formerly worst sectors outperform
3. 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!

Comments

[Valley Boy:]

The fundamentals might be addressed by traders in a more
serious way after Labor Day when their summer vacations are over
and when there wil be more trending data to sift through.

Jun 11 02:40 PM

[Swashbuckler:]

"....but at some point, the great rally of 2009 will end. When it does, it will be quite ugly." Not if you're short.

Jun 11 06:34 PM

[BPYHO:]

JASO baby, JASO!

Jun 11 06:37 PM

[texalope:]

I disagree. Banks borrow short and lend long. They are making money every day. Retailers business is improving. Housing has improves. Check out the recent Hovanian conference call. Looking in the rear view mirror will not make money for you. In 2007 the people looking through the windshield made money. The same holds true today.

Jun 11 07:04 PM

[Fitz919:]

I'm sticking with my short positions. This things comin down.

Jun 11 07:51 PM

[Moon Kil Woong:]

Texalope: When banks borrow short and lend long at say 5% then inflation and yields go to 7% what happens to their portfolio? Oppps. Then when 10% of them default then what happens?

Although they think they are getting a good deal borrowing from us (the taxpayer) at low rates thanks to Fed and Treasury lifelines, there is not enough money in the universe to cover their catacysmic business long term model when the market is falling. The best they can hope to do is dump their losses onto Fannie Mae and Freddie Mac before the public stops funding their perpetually bad business model so the taxpayer gets it both from end and from the back end.

True banks are using their profits to pay off their losses, but this will take years and years. Sure banks are raising money, but this is largely to repay TARP not get substantially healtier nor lend more to good customers to increase their base to cover bad loans.

If you are depending on the banking industry to save us you are dreaming. The banking industry is the one who constantly needs saving. They haven't saved anyone since they were conceived.

Jun 11 11:21 PM

[untrusting ...:]

Very well stated. Could not agree more. The market would probably have started to retrace the bear market rally already, were it not for the "unusal activity" seen so often to prop up the market. The suspects being Goldman Sachs, JPM and the TARP banks using Fed liquidity. As Tyler Durnan has so often shown in his Seeking Alpha articles, the last minute "unusual activity" near the end of trading days has propped up the market on many occasions. In additon the recent major oil price mainpulation by Goldman and others has also had a significant impact on the market. But would certainly would agree with you that it cannot go on indefinitely.

Jun 12 12:33 AM

[sethmcs:]

The premise of your article is the "bad assets" have not been cleaned up and banks are still insolvent. I disagree. All derivatives are not losers, especially if they are hedged and CBO are not worthless. If they are give them all to me. lol. What has happened is the mark to market rule made all these instruments appear to be worthless because you can't mark to market without a market. What is going to happen now is these assets will be wrote up and the interest rate spread will allow the banks to start making some serious money. I bet most banks will beat earning expectations which are already low. If you feel that I am wrong go ahead and short the financials. I am accumulating regional banks now and avoiding the majors. If I am wrong the juicy yields will allow me to be patient.

Jun 12 01:13 AM

[will28307:]

I would like to buy an "R" for your logo...

Jun 12 02:11 AM

[jeremiah74:]

it would be interesting to really find out whether those last hours surges in the indices were really done by the TARP repayers to maintain the market allowing them to raise money to repay the TARP.
it woud make sense. and its probably not illegal either. nevertheless if it were true (i dont know) then once the TARP is repaid there will be no more buying, and some of the positions will have to be reversed

Jun 12 03:27 AM

[YoYoMama:]

Unfortunately, the bill introduced earlier this year to reinstate the uptick rule is currently dying on the vine in Committee. See: www.govtrack.us/congre....

I bet when the market starts plunging again this bill will get back on the front burner.

Jun 12 08:39 AM

[User 429526:]

Has anyone looked at the transports? Worse than post 911 days..If transports are a leading indicator of which way the market is heading, why are they at yearly lows....

Jun 12 08:55 AM

[Moosehead333:]

Very good article. As of this morning I am selling all of my stocks with a modest profit. I might go short the S&P 500 with the ETF SDS if the SP500 falls below 910. But it appears to me the drive up in the market came from institutional buyers and that buying is starting to decrease in volume. When volume decreases and support resistance is breached, the market usually goes lower with heavy institutional selling by the same people who drove the market up. I am not a market guru by any stretch of imagination, just a stock trader now and then. The over 40% increase in the markets in the last several months does not seem to me sustainable in the short run. Time for me to take profits and get out. I agree with the author, it will get ugly.

Jun 12 11:34 AM

[fwi:]

The market has been propped up so that the banks could finish their secondaries. A short interval has ensued so that investors would not later link the pop up to the serious leg down that will shortly begin.

Jun 12 12:03 PM

[Old Trader:]

sethmcs,

Something to consider; although the regionals kept their skirts clean of the gunk known as derivatives, CDOs, MBSes, etc, they dove headfirst into the CRE market. A lot of people are looking for that chicken coming home to roost, in short order. Fwiw, I'm steering clear of the whole financial sector, for the time being.


On Jun 12 01:13 AM sethmcs wrote:

> The premise of your article is the "bad assets" have not been cleaned
> up and banks are still insolvent. I disagree. All derivatives are
> not losers, especially if they are hedged and CBO are not worthless.
> If they are give them all to me. lol. What has happened is the mark
> to market rule made all these instruments appear to be worthless
> because you can't mark to market without a market. What is going
> to happen now is these assets will be wrote up and the interest rate
> spread will allow the banks to start making some serious money. I
> bet most banks will beat earning expectations which are already low.
> If you feel that I am wrong go ahead and short the financials. I
> am accumulating regional banks now and avoiding the majors. If I
> am wrong the juicy yields will allow me to be patient.

Jun 12 06:36 PM

[Gary Griswold:]

Yes, it took months for the stock market to accept there was a problem in 2007 and turn down. So, you conclude that there should also be an equal delay between reality and a market upturn? No, I think stock market history is very clear that markets start rising well before the end of a recession, and markets fall only after the bubble bursts.

A similar example of this (on a smaller time scale) can be found in the Yen carry trade of the past few years. Each time that the dollar/yen started to decline it took a couple of weeks for Yen carry trade to slow down. And yet as soon as the dollar/yen started to rise the Yen carry trade returned.

I am not positive how to characterize this asymmetry between up-turns and down-turns except to conclude, possibly this occurs because more people are optimistic than pessimistic.

By the way, I am not saying that we have seen the bottom of this market, and I don't know where the market will go from here. I hope up.

Jun 12 09:15 PM

[cljenn01:]

Proposals to reinstate the “uptick rule” are insufficient half-measures. Benjamin N. Dover III's letter to the SEC proposing a complete ban on stock selling as the solution to market volatility lays out the truth...

Truth #1: Stock Market Crashes Are Caused By Stock Sales.
Truth #2: True Investors Buy And Hold. Forever.
Truth #3: “Buy And Hold” Guarantees An Ever-Rising Market.
Truth #4: A Rising Market Makes People Happy.
Truth #5: The SEC’s Job Is To Stay Out Of The Market When It’s Rising And Step In To Appropriately Alter The Rules When It’s Falling.
Truth # 6: Stock Sellers Are Short On America.


On Jun 12 08:39 AM YoYoMama wrote:

> Unfortunately, the bill introduced earlier this year to reinstate
> the uptick rule is currently dying on the vine in Committee. See:
> www.govtrack.us/congre....
>
> I bet when the market starts plunging again this bill will get back
> on the front burner.

Jun 13 12:01 PM

[gksmar:]

If you cannot market to mark because there is no market, then the value of the asset is zero because there is no market for it.
That is what free markets are my friend.


On Jun 12 01:13 AM sethmcs wrote:

> The premise of your article is the "bad assets" have not been cleaned
> up and banks are still insolvent. I disagree. All derivatives are
> not losers, especially if they are hedged and CBO are not worthless.
> If they are give them all to me. lol. What has happened is the mark
> to market rule made all these instruments appear to be worthless
> because you can't mark to market without a market. What is going
> to happen now is these assets will be wrote up and the interest rate
> spread will allow the banks to start making some serious money.
> I bet most banks will beat earning expectations which are already
> low. If you feel that I am wrong go ahead and short the financials.
> I am accumulating regional banks now and avoiding the majors. If
> I am wrong the juicy yields will allow me to be patient.

Jun 13 12:05 PM

[User 305589:]

Retailers improving? Just look at the latest redbook!
Hovnonian bullish on housing? Well, they have been bullish all the way till today, at least in their verbal communication. Somehow the Hovnonians sold a boatload of their company's shares along the way into rallies. And given the way they led their company into the housing meltdown with full steam and a ton of leverage, you better do not count on the Hovononians as accurate fortecasters of their own industry. Sort of listening to Citi or Fannie and Freddie and then to expect any useful clues about the coming trends in banking and mortgages.


On Jun 11 07:04 PM texalope wrote:

> I disagree. Banks borrow short and lend long. They are making money
> every day. Retailers business is improving. Housing has improves.
> Check out the recent Hovanian conference call. Looking in the rear
> view mirror will not make money for you. In 2007 the people looking
> through the windshield made money. The same holds true today.

Jun 24 08:58 AM