Why I'm Getting Bearish Again

You have probably noticed a change in tone at Credit Writedowns since about June, but a lot more in the past month or so. Once mildly bullish due to the deeply oversold levels this Spring, I have become increasingly alarmed at the unjustified strength of the recent market rally.

My most recent post explaining my concern, “Major selloff coming?” kind of gives you the timeline. I really would like to be bullish, but I have major issues with this rally on both a technical and fundamental basis:

Technicals

1. The technicals all point to stock markets in the U.S., Europe and Emerging Markets as being overbought. This has been the case for at least two months now. As the market continues up without a pullback, you have to be concerned that any pullback will be violent.
2. There has been an enormous multiple expansion, which is usually what occurs in the middle to latter stages of a secular bull market, not in the beginning of one. It certainly makes one think this is a bear market rally and not a secular bull move.
3. I have said that the massive liquidity dumped into the system is not going to fuel inflation when capacity levels are at historic lows in the U.S. There is absolutely no pricing power, either for businesses or workers. But, all that money is going somewhere eventually. Right now, it looks like it’s going into asset prices. Liquidity is seeking return.

Fundamentals

1. If you look at the deflationary pressures, they are almost all still at work: poor employment markets, producer price inflation at record low levels (Germany down 7.8% through July y-o-y for example), overcapacity in Europe, China and Asia, back breaking debt levels, etc, etc.
2. But, then, where is the demand? It’s not there. The consumer is not going to be jumping in here. A lot of the uptick in the economy is inventory-related, not consumption-driven. So either former exporters, government or business will have to pick up the slack.
3. And let’s not forget my favourite whipping boy, the financial sector. In the U.S., there are a lot of toxic assets on balance sheets, while leverage and equity capital ratios are still poor. That speaks to the need for continued deleveraging and low loan growth in the financial services sector.

So while a snap-back rally was inevitable given how oversold things had become in March, this rally has been a bit over the top. I am not alone in this assessment. The Wall Street Journal has pointed to Jeremy Grantham and a few other March bulls who are now speaking in more cautious tones.

…Jeremy Grantham, penned a note on March 10 entitled "Reinvesting When Terrified" that encouraged investors to buy, suggesting stocks were 30% undervalued.

Since then, the market has roared ahead, without stopping for a correction of 10% or more. Standard & Poor’s 500-share index ended last week at 1026.13, up nearly 52% from its 12½-year low on March 9 and its highest close since Oct. 6. The Dow Jones Industrial Average is at 9505.96, up 45% since its March low.

Now, the chairman of Boston asset-management firm GMO and his colleagues say the S&P 500 has zoomed right past what they consider fair value of about 880, based on earnings estimates and historical price-to-earnings ratios.

Notice the part about not having had a correction, which I see as a contrarian indicator. Back in May, Grantham said a leap up to 950 and then a sideways move between 950 and 1050 on the S&P meant the market was modestly overpriced. That is not a sell signal. This is where we are right now. But, at 1026, we are dangerously close to breaking out of that range to the upside – which would be a sell signal.

With the City and Wall Street ready to return to full speed soon, we will get a better taste of what is to come due to higher trading volumes. But, for now, I am mildly bearish on shares.

Comments

[Roger Knights:]

"But, at 1026, we are dangerously close to breaking out of that range to the upside – which would be a sell signal."

As close as eight hours away, perhaps.

Aug 24 04:00 AM

[QuasiYoda:]

Wonderful article! Regarding the SPX we have retraced over 38.2% ( at 1014.14 S&P) of the Drop from 1576.09 (Sept 07 High) to the 666.79 (March 09 Low). We could certainly Fall from here but recent action has shown a lack of vigor on bear side. The bears simply did not sell when the time was ripe. So it seems the next target could be 1121.44 the 50% retracement of the aforementioned Drop. The 1228.74 level is a full 61.8%

It should be mentioned that as we retrace more and more of the Drop (without a strong consolidating retrace needed to strengthen this price structure) we are setting up a sharper and harder resumption of the Bear market. All the while Shill TV will ironically become ever more optimistic and arrogant.

This entire rally from the early March Low of 666.79 to 1026.13 has occurred without a single retrace of 38.2% or better. This makes for an unstable price structure for long term bullish stability yet (the irony continues), we have retraced 38.2% of the Drop from Oct 07 thru March 09 which does stabilize that bearish price action.

These retracement percentages 38.2%, 50% and 61.8% are proportions found in natural structures from plants to animals to stars and solar systems. These proportions provide structural integrity. Right now it looks like the bears have it and the bulls racing frantically ahead forgetting to build a solid structure for future rallys. Doesn't mean we can't rise to the 1121 or 1228 levels but I see a powerful selloff occurring once this bull trend is broken. This is a Fast Sharp Retrace in a Bear Market . . .

Aug 24 06:42 AM

[Value Added:]

I like this analysis, Edward. I believe your statement "...all that [bailout] money is going somewhere eventually. Right now, it looks like it’s going into asset prices." is very true, and the effects are magnified by light volumes. Deleveraging takes time, and time hasn't been allowed to take its course. I expect significant correction shortly, and although I moved substantially out of equities about 2 weeks ago, I have no regrets even though the market has continued its irrational trend up awhile longer. What I'm interested in identifying now are those rare stocks that will continue to perform in a stagflation environment. Thanks again for your article.

Aug 24 08:43 AM

[inthemoney:]

> I have said that the massive liquidity dumped into the system is not going to fuel inflation when capacity levels are at historic lows in the U.S. There is absolutely no pricing power, either for businesses or workers. But, all that money is going somewhere eventually. Right now, it looks like it’s going into asset prices. Liquidity is seeking return.

Exactly.

Aug 24 08:54 AM

[E Nuff Sed:]

Edward, Good analysis as usual. I enjoy reading your work. While Grantham is of course legendary and prob. right that the overall market is about 20% over-valued over fundamental at this moment of time.
However there are 2 things to consider - most of the rally has gone into extremely beaten down financial, retail, resources and other stocks (many of them have taken huge write downs). There is still tremendous value out there in consumer staples, healthcare in particular.

Second is the very low interest rate environment. Not only is there a lot of money on the sidelines but tremendous amount of money has been created by the Fed. It is and will be for some time trying to find a home.
Therefore I think after a pull-back the rally will restart again - and will continue until the Fed starts tightening again. S&P 1200 is possible by year end with S&P 1400 some times next year is not out of the question, esp if we start seeing some inflation.

Aug 24 01:34 PM

[E Nuff Sed:]

Another thing - could you provide some support for this statement,
"There has been an enormous multiple expansion, which is usually what occurs in the middle to latter stages of a secular bull market, not in the beginning of one".

Aug 24 01:37 PM

[veryold:]

Prudence pays. Another minus 300 day perhaps? This just doesn't feel real. Appreciate your analysis. Thanks.

Aug 24 02:32 PM

[Maxe Paul:]

Today i received three emails by market "experts" (code for morons) who (all three) are declaring this a new bull market, and saying we told you so, we are right, everyone is wrong, we are the experts we knew this was a bull market and told everyone, but no one believed us!

As soon as i read these fools i knew we were getting very close to the top of the bear market rally, shouldn't be long now, i expect mid September.

Good article, its obvious to the trained eye this ain't no bull market.

Aug 24 09:07 PM

[Maxe Paul:]

I think he means share price expansion, shares do not go up 10% a month in a bull market, more like 10% a year, and that's a good year!

It has the feeling of a bull market top, when everything pops higher on no fundamentals, just rampant speculation.


On Aug 24 01:37 PM E Nuff Sed wrote:

> Another thing - could you provide some support for this statement,
>
> "There has been an enormous multiple expansion, which is usually
> what occurs in the middle to latter stages of a secular bull market,
> not in the beginning of one".

Aug 24 09:12 PM

[untrusting ...:]

If you are looking for a good article on "multiple expansion", then do a search on Seeking Alpha for the author below:
Vitaliy Katsenelson
He has a link to a 20-page document that talks about it in his mid August SA article. Makes a lot of sense and is well worth the time to read it. Title of article is "We're Trapped in a Market Going Nowhere Fast", but the link is embedded in the article and shows a pretty good analysis of why and how bull, bear, rangebound markets happen and how multiple expansion/contractions affect them.


On Aug 24 01:37 PM E Nuff Sed wrote:

> Another thing - could you provide some support for this statement,
>
> "There has been an enormous multiple expansion, which is usually
> what occurs in the middle to latter stages of a secular bull market,
> not in the beginning of one".

Aug 25 12:40 AM