The Three Phases of This Bull Market

The stock market rally since early March appears to have three distinct phases to it.

The first phase was the backing off from the economic abyss. The second phase was a bounce to fair value normalcy. The third phase (the one we are in now) is what I would call the return to business as usual phase (or “Recession. What recession?).

From where I sit, the first two phases were justified on many levels. Both phases featured massive amounts of government intervention combined with strong technicals to produce a rally to fair value. The elimination of the tail risk of the Great Depression II was followed by the above consensus macro economic readings (my MERI indicator), which was reinforced by the above consensus earnings results of 2Q09. Stocks rose to a reasonable fair value. So far, so good.

Unfortunately, at this point the seeds of questionable earlier decisions began to bear fruit. (Now, this is going to sound very libertarian, so here goes.) Instead of pursuing the necessary cleansing process that all excesses produce, the Obama administration (which includes the U.S. Treasury and the “independent” Federal Reserve) opted for a massive debt transference from the private to the public sector with the hope that time will heal all wounds. Along with this decision to socialize the bad behavior of the private sector most responsible for the crisis, the financial services industry, the Obama administration supported its core structure built on the laissez-faire era of the past two decades, accepting the largely unsubstantiated argument that financial innovation is a vital and necessary good for the economy.

With the government’s tacit support of the status quo, the investment mood shifted from fear and concern to hope and then enthusiasm.

The evidence of this mood shift back to the animal spirits days of yore came from a logical source – the financial services industry, the very sector of the global economy that provided the financial innovation grease to the out of control freight train of credit. And what better symbolic locomotive than Goldman Sachs, whose earnings report of July 14th whistled the bad old days were back in action. At this point, the Obama administration swung into action – with silence.

With its absence of outrage, the increasingly politically tone deaf Obama administration sent the public policy signal that it's okay to bring the world economy to its knees, it's okay to get bailed out with taxpayer money, it's okay to shrink the competitive landscape (via Bear and Lehman’s demise), and it's okay to return to the way things were – big profits and in your face fat bonuses.

The product of this wink and nod to Wall Street was the backlash at town hall meetings, which were as much about fairness as they were about healthcare reform concerns, a paranoid view of government, and a reactionary view of what constitutes being an American. It also produced an enthusiasm for stocks and an implied return to the bad old days.

Investment Strategy Implications

When you combine all these factors with the massive amount of investment capital ($3.5 trillion) still sitting in the near zero interest rate money market sidelines, the rising belief among many institutional investors that P/Es above their historical average are justified in the current low inflation environment, and the fledgling confidence that the global economy is on the mend* (along with the blind faith that the economic data from China is real), it is understandable how valuation levels could get to where they are today – stretched.

The investment question then becomes, “Is this a solid enough foundation upon which sustainable bull markets are built?” I have my doubts.

*I suggest reading Nouriel Roubini's comments in Monday's FT.

Comments

[Dave Wrixon:]

The problem as I see it is the Banks, the Fed and the Treasury have all contrived to ensure the "Fair Value" is impossible to determine, particularly with banks. The black holes in the balance sheets have been camouflaged by changes in accountancy rules to the assets can be allocated whatever value is required to make the numbers work. Profitability has been bolstered by lending cheap and then borrowing back dear, whilst the banks take a good margin for loans of neglible risk that involve no marketing. Even if the loans turn bad and the government becomes insolvent, the banks don't have to worry as that is where the money came from in the first place. Indeed, it is getting quite difficult ot work out how much liquidity is being created from thin air.

Other sectors have not faired quiet as well as much of the Cash for Clunkers money actually went straight to the Japanese, but even so much of American commerce is selling to market that flatter there competitive position because they are being supported by government finance. That is even true of the Real Estate market.

So how the hell can you asses the legitimacy of a stock market rally base on some hazy notion of fair value? You have no idea whether most of the companies are going to be turning a profit next year when dollar collapse means that finance is going to get very expensive indeed. Even with the abandoment of Mark to Market, there is some point beyond which plausible deniability in terms of valuations is not particularly viable. Therefore the flattering of balance sheets and profit and loss accounts is essentially a one off free lunch. Next year everything will be base on fundamentals which could be very dire indeed, especially if the goverment is forced raise taxes just as the Fed is coersed by the market into setting hire interest rates.

Aug 27 07:23 AM

[Danny Furman:]

Hard to argue with the description of the "3 phases," thanks for the article. It seems today's sentiment is overwhelmingly bullish, yet projections are non-existent or call for very little upside. Even "expert analysts" are saying to buy momentum now instead of value. This is not sustainable.

Aug 27 08:59 AM

[Michael Clark:]

Is the PE for the S & P 500 stocks really at 144? Is this a 'green shoot' or a 'brown shoot'?

Aug 27 11:48 AM

[Boxed Merlot:]

…When you combine all these factors with the massive amount of investment capital ($3.5 trillion) still sitting in the near zero interest rate money market sidelines,...

Does 2:00 pm est September 18, 2008 ring a bell to anybody? If I remember correctly, that’s when several hundred billion of these $ were being removed and caused the run that is only now trying to be unraveled by Bloomberg’s request of the Fed to disclose where the money went. With the Fed currently sitting on 2T “in reserves” this time around, it appears they’re ready to up the ante and liquidate the value of these $ further through hyperinflation / taxation if and when the music stops again. Phase IV anyone?

Aug 27 12:05 PM

[Larry House:]

We do not have fundamental data that indicates the recession is over. Market action does not end the recession. A bear market rally does not a bull make.

Unemployment is not improving. The number of problem banks is increasing. Consumers are very cautious.

That money sitting in money market accounts may NEVER come back into the market. Boomers are retiring in great numbers, and they may be cautious the rest of their lives.

Aug 27 02:43 PM