Strong Start for Bull Market, But Investors Are Nervously Eyeing the Exits

The bull market that began on March 9 has gotten off to the strongest start of any bull market in U.S. stocks since 1940 (see chart below). Given (i) widespread perceptions that stocks have "come too far too fast" and the economic recovery is largely government-induced and not sustainable, and (ii) that we have entered the traditionally weak months of September and October (with last fall’s carnage the most recent historical example), our sense is that many investors are nervously eyeing the exits.

Click to enlarge:

The risk/reward relationship in stocks has indeed deteriorated as a result of the large gains from the March lows, and it is quite possible that this cyclical bull market has already produced the majority of the total returns that it will ultimately deliver - before another bear phase intervenes. However, it would be very premature to assume that the upside potential of a bull market that is less than six months old is exhausted, or nearly exhausted. If a correction does develop this autumn – and one may well have begun last week – we doubt that the August highs will turn out to be anything more than an interim peak in stock prices. There is scant evidence of major topping behavior in the stock market. From a technical standpoint, the stock market looks quite attractive. The technical indicators we track, in terms of both breadth and leadership, are firmly in bullish territory. Sentiment indicators are mixed, but overall reflect enough skepticism to suggest that corrections will be limited in scope.

Stock prices have indeed come a long way from the early March lows, but the size of the initial rally has been proportionate to the scale of the preceding bear market decline, which was the largest since the 1930s. Thus far, this bull market has only recaptured about one-third of the losses registered by the S&P 500 from October 2007 to March 2009. Moreover, the S&P 500, currently trading at 1000, is still 575 points, or 36%, below its previous bull market peak reached in October 2007. A large portion of the stock market’s gains in the past six months reflects the removal of the “Armageddon Scenario.”

Today, the risks of economic depression, financial collapse, and an unstoppable deflationary spiral have clearly been priced out of the market, but the S&P 500 is still over 20% below the levels prior to the collapse of Lehman Brothers last September. The conditions for a robust economy recovery are missing. Instead, the recovery is likely to be anemic and fragile. But the case for a deflationary relapse, which would pose the greatest risk to stock prices, is weak. If such a scenario was imminent, we would be seeing rising corporate bond spreads, strength in the dollar, lower gold prices, and a rally in Treasury bonds. Only the last one of these market signals – strength in Treasuries – has been observable.

Comments

[logicalthought:]

Am I the only guy who thinks that "J.D."s picture looks exactly like Charlie Sheen in "Wall Street"? Come on, J.D.... Stop SENDING us information, and start GETTING us some!

Sep 06 09:23 AM

[Nick36:]

When the fundamentals don't support high stock market valuations. Then any rally is most likely a bear market rally and not a new bull market.

And you've got to remember that some of the most vicious bear market rallies happen during the worst recessions and depressions.

Eyeing the exits makes sense when the reported P/E of S&P 500 is 129.19. Such a high P/E ratio of the stock market has never happened before in the entire history of the stock market, until the present recession.
www2.standardandpoors....

Sep 06 10:20 AM

[markfl:]

The deflation debate is perennial, and I suppose it depends in part upon how much you are willing to trust some of ECRI's information. As for the near term outlook, their gauge points to inflation due to commodity prices rather deflation: "The July USFIG [inflation measurement] annualized growth rate, which smoothes out monthly fluctuations, shot higher to 6.5 percent from negative 8.8 percent in July, revised from negative 8.6 percent." www.reuters.com/articl...

Sep 06 10:43 AM

[Alphameister:]

Good article (meaning your assessment of the evidence comports with mine). If Nick36 is serious in citing a p/e of 129.19 (could we get a third decimal in the interest of real precision?), he should not be playing the stock market. I'm net short the US market based on short-term concerns combined with an unexciting long-term reward-risk ratio, and net long China despite some short-term concerns there as well.

Sep 06 11:41 AM

[mloren:]

It is remarkable how little any of us really know in terms of direction and the market can turn on the head of a needle. The unemployment is the key issue. It's horrible. Alphameister's shorting the us market seems to be the next play.

Sep 06 12:31 PM

[Ricard:]

I also agree with the tone of this article (caution is warranted given the recent rally). In defense of Nick36, he's just citing Standard and Poors. I will say though, that P/E (especially aggregate P/E) has less meaning in a vicious bear - I believe S&P gets their number by dividing aggregate market caps by aggregate earnings - this would include enormous losses at whatever financials are still on the index. There are still some healthy companies out there, and although I would say they would merit a closer look, the unreasonable strength of this rally makes me more cautious.

Back to P/E - tech notwithstanding - P/Es may go *down* in a strong bull market, as leveraged companies wildly profit from their speculative operations and investors slowly get more and more cautious. Just look at home-builders in 2002-2006.

On Sep 06 11:41 AM Alphameister wrote:

> Good article (meaning your assessment of the evidence comports with
> mine). If Nick36 is serious in citing a p/e of 129.19 (could we
> get a third decimal in the interest of real precision?), he should
> not be playing the stock market. I'm net short the US market based
> on short-term concerns combined with an unexciting long-term reward-risk
> ratio, and net long China despite some short-term concerns there
> as well.

Sep 06 12:59 PM

[RECESSIONPROOF:]

exit no monday

Sep 06 02:25 PM

[David Van K...:]

With regard to the S&P's PE ratio: (1) The 129 PE ratio is directly from S&P. It is statistically correct in that it follows their usual methodology, which is to divide the current value of the index ("P") by their highly massaged TTM earnings number ("E"). They have to massage the actual earnings (and stock prices) to keep the index continuous when they replace one stock with another. (2) S&P's methodology, many will remember, has come under criticism for not weighting the "E" in the same fashion the index itself weights the stocks in the index. S&P believes the criticism is unwarranted. (3) As to Ricard's comment, TTM "E" is NOT changed when S&P replaces a stock. Once posted, S&P keeps all former quarters' "Es" unchanged, even if some of the stocks in the former calculation have been removed from the index. (4) S&P has replaced about 40 stocks in the last calendar year. Therefore, several of the companies with the worst earnings (especially huge losses in Q4 2008) that contribute to the current 129 PE are no longer in the index. If past "E" were restated to reflect the current companies in the index, the PE would be much lower.

Sep 06 04:28 PM

[Albertarocks:]

On Sep 06 11:41 AM Alphameister wrote:

> Good article (meaning your assessment of the evidence comports with
> mine). If Nick36 is serious in citing a p/e of 129.19 (could we
> get a third decimal in the interest of real precision?), he should
> not be playing the stock market.

What was it exactly that Nick36 said that was worthy of criticism? How do you come to the conclusion that since he quoted a p/e ratio of 129, he shouldn't be playing the stock market? I'd think you'd select someone else to pick on considering that Nick's statement is not only true, but it supports the fact that you're net short the US markets.

I've definitely got a bias toward lower prices, but it never ceases to amaze me how many late day and late week stick saves we're seeing. I fear that type of blatant market gaming just might go on for a lot longer than we think, when you consider the trillions of stolen dollars that the piggy bankers have at their disposal. It's pretty aggravating when these stick saves show up to save the day and we find out that 40% of shares traded on some days are on deadwood, flat broke zombie banks. Who's impressed with that? That's not what constitutes a realistic market rally.

Every indicator out there is screaming for at least some sort of serious correction, if not a full blown resumption of the market's ultimate direction. But as long as the pigs are going to get away with the manipulation that's as obvious as the nose on your face, it sure is difficult to be short for very long. But one thing's certain, that's going to change. I expect this rally is going to ultimately end with some sort of earth-shaking external event. If I'm not mistaken, that would include nuclear. You know how Wall Street loves to "surprise" the investor. But first, JPM will naturally load up on the appropriate puts.

Sep 06 04:45 PM

[Dialectical...:]

Regarding all the P/E talk, I think it is obvious that a number of factors inflate the S&P 500 figure. But even allowing for distortion, my sense on the face of it is that the market has priced in business as usual for many companies when anyone not living in a cave can surmise that business is not usual. The only question that has me confused is exactly when is the market going to price in the actual earnings of these businesses over the next couple of years? Is there going to be a massive sell-off when Q1 2010 numbers come in lower than expected (lower than priced-in I mean), or will there be a gradual taper towards more realistic P/E's. Or lastly will there be a sideways market for the next 4 years while we wait for companies to actually catch up to their stock prices (maybe helped by inflation)? The only thing I can't see happening is this incredible rally continuing indefinitely while top line revenues continue to stagnate or decline. You can't time the market. At least I can't. So I'm trying to pick some good companies and holding back as much money as I can stomach to see when the (hot) air comes out of these balloons.

Sep 06 05:39 PM

[Ricard:]

Thanks for the explanation.


On Sep 06 04:28 PM David Van Knapp wrote:

> With regard to the S&P's PE ratio: (1) The 129 PE ratio is directly
> from S&P. It is statistically correct in that it follows their
> usual methodology, which is to divide the current value of the index
> ("P") by their highly massaged TTM earnings number ("E"). They have
> to massage the actual earnings (and stock prices) to keep the index
> continuous when they replace one stock with another. (2) S&P's
> methodology, many will remember, has come under criticism for not
> weighting the "E" in the same fashion the index itself weights the
> stocks in the index. S&P believes the criticism is unwarranted.
> (3) As to Ricard's comment, TTM "E" is NOT changed when S&P replaces
> a stock. Once posted, S&P keeps all former quarters' "Es" unchanged,
> even if some of the stocks in the former calculation have been removed
> from the index. (4) S&P has replaced about 40 stocks in the last
> calendar year. Therefore, several of the companies with the worst
> earnings (especially huge losses in Q4 2008) that contribute to the
> current 129 PE are no longer in the index. If past "E" were restated
> to reflect the current companies in the index, the PE would be much
> lower.

Sep 06 06:14 PM

[buddhabill:]

In my completely off-the-cuff, un-supported by any technical, fundamental or quantitative analysis, the real death-knell for the current rally will be anemic holiday retail sales. Consumers are tapped-out, still trying to unwind from a decade + of excess consumption and the accompanying debt.

Quality job growth is slow, under-employment, the shadow twin to actual on-the-books unemployment is tremendous, and savings is on the rise.

This jobless recovery is like foam - it can look 'solid' but cannot actually support any substantial weight.

So it will not surprise me if the market does manage to push SPX to 1200 before year-end profit taking exacerbates the dreadful retail story and a full-on rush for the exits ensues.

Is the play here to sell Jan OTM SPX calls and buy ATM (or near OTM) Nov or Dec calls with the proceeds? $0 cost if we crash before the early expiration, risk only if the V extends for an unprecedented 10th month...

Sep 06 06:42 PM

[buddhabill:]

Make that SDS Jan - Dec. calls (i.e. sell Jan 55, buy Dec 50)

Sep 06 06:56 PM

[Per:]

This is a bear market rally and as such we could get to the 50% fib before the correction is over.

Sep 06 10:14 PM

[JeffDB:]

Check out Hitler's reaction to & assessment of the rally:

www.youtube.com/watch?...

Sep 06 11:24 PM

[Erick Tippett:]

Sir,

You don't define whether this is a secular bull market or a
cyclical bull rally in a larger trend bear market secular in
nature. As a consequence your information could be harmful
to inexperienced investors who don't have the educational
background in market cycles to differentiate between the two!

Try to be instructive as well as analytical in your future articles.

Thank you.

Erick Tippett
Chicago, Illinois

Sep 07 12:21 AM

[contango:]

" If past "E" were restated to reflect the current companies in the index, the PE would be much lower."

So what's the answer?


On Sep 06 04:28 PM David Van Knapp wrote:

> With regard to the S&P's PE ratio: (1) The 129 PE ratio is directly
> from S&P. It is statistically correct in that it follows their
> usual methodology, which is to divide the current value of the index
> ("P") by their highly massaged TTM earnings number ("E"). They have
> to massage the actual earnings (and stock prices) to keep the index
> continuous when they replace one stock with another. (2) S&P's
> methodology, many will remember, has come under criticism for not
> weighting the "E" in the same fashion the index itself weights the
> stocks in the index. S&P believes the criticism is unwarranted.
> (3) As to Ricard's comment, TTM "E" is NOT changed when S&P replaces
> a stock. Once posted, S&P keeps all former quarters' "Es" unchanged,
> even if some of the stocks in the former calculation have been removed
> from the index. (4) S&P has replaced about 40 stocks in the last
> calendar year. Therefore, several of the companies with the worst
> earnings (especially huge losses in Q4 2008) that contribute to the
> current 129 PE are no longer in the index. If past "E" were restated
> to reflect the current companies in the index, the PE would be much
> lower.

Sep 07 12:53 AM

[bbro:]

S&P is priced at 7% of Gdp which places it well below the 60 year
median....,if we don't get a freakout we have more room to run....

Sep 07 05:11 AM

[Albertarocks:]

I guess there's more than one way to look at statistics. If the S&P returned to the 60 year median 15 times the p/e ratio (the real p/e ratio, not a p/e ratio based on "guesses" about future earnings), it would be trading at 103.



On Sep 07 05:11 AM bbro wrote:

> S&P is priced at 7% of Gdp which places it well below the 60
> year
> median....,if we don't get a freakout we have more room to run....

Sep 07 12:21 PM

[untrusting ...:]

Richard,
PE ratios very much depend on which earnings one is talking about. Is it estimated forward earnings, operating earnings, as reported earnings? Estimated forward earnings and operating earnings tend to be much higher than as reported earnings (actual earnings), and thus are often used to attempt to justify higher stock prices. The fact is they are really not very reliable and are subject to much more bias and subjectivity.

Probably the least subjective PE ratios are what as known as PE10 ratios. See Doug Short's site at dshort.com for some great analysis and statistics on PE10 ratios. Shiller has written a lot about PE10 ratios as well, as have several others.

But probably even more important than the pure PE ratio itself, is the large multiple expansion in PE's from the March lows to present. Another factor is the far above average margins (unlikely to repeat) embedded in 2007/08 PE's. If one remembers correctly there is a pretty good analysis of this on John Hussman's fund website. Hussman is definitely a true skeptic about this rally and is fully hedged. Hussman has a lot of good analysis and articles on his site and is well worth some time spent reading his articles. For example the following article provides some good analysis of PE stats.
www.hussmanfunds.com/r...

On Sep 06 06:14 PM Ricard wrote:

> Thanks for the explanation.

Sep 07 10:44 PM