The End of the Bear Market?

by: Alan Brochstein, CFA

For someone who has been bearish since the early summer, the demise of one of the major broker-dealers is the kind of news that makes one believe that the thesis may have pretty much played out. While my recent bullish article (Get Ready for the Last Rally) appears to have been slightly premature, I want to reiterate that I believe we are about to experience a very powerful bear market rally.

While those espousing the cockroach theory feared that the Bear Stearns (NYSE:BSC) mess is just the tip of the iceberg, I believe that the deeper take-away is that while several of our financial institutions may fail (the problem with huge leverage amidst tight credit), the Federal Reserve Board will not let our financial system fail. I have been critical of rate cuts as a “solution” since before the Fed even began the easing process, but I have to give kudos to them for the recent, though belated, actions, both of which address specifically disorder in the markets. It is terrible for the shareholders and employees of Bear Stearns, Countrywide (CFC) and some of the other implosions, but it is part of the necessary correction process for the excesses over the years.

History is ripe with broker-dealer failures. Two that stand out in my career were Drexel Burnham Lambert in 1990 (about one year after the Fed had jacked Fed Funds to a stunning 10% and just as the U.S. was entering recession) and Kidder, Peabody in 1994. In both of these cases, stocks ended up being a terrific buy later in those years. Will that be the case this time? I continue to expect that stocks will struggle again later this year (assuming my rally call proves correct), but the reason won’t be so much the financial Armageddon that people are increasingly fearing but rather a squeeze on corporate profit margins amidst sluggish albeit recovering economic growth but stubbornly high input costs such as materials and labor. The fear of capital gains tax hikes too could prove problematic. It still looks to me like we will have the typical seasonal patterns, with some angst around the elections as well.

I highlighted the reasons to expect a rally in the article referenced above, citing primarily excessive negative sentiment. When I wrote the article (3/5), the Financial Sector ETF (NYSEARCA:XLF) had closed at 25.15 and traded there on early Friday after CPI, but it fell after the BSC announcement (though not making a new low for the week). It has traded between 23.5 and 25.90 in the past 6 trading sessions. I expect Financials to be one of the strongest movers in this “last rally” (which may have started last Tuesday), with the potential for XLF to trade to at least 29 and perhaps somewhere between 30 and 32. I guess we need to get through the broker-dealer reports this week first.

Adding to my confidence that this is a great time for a bear like me to catch the proverbial falling knife is that there is a stealth rally going on in Financials. No, not in the big ones, that tend to be overleveraged and illiquid, but rather the smaller companies. Note that the Mid-Cap and Small-Cap Financial stocks are performing exceptionally this month. If the world were coming to an end, as some would have us believe, then I don’t think that investors would be running these stocks up.

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So, it was a strong week for smaller Financials. In fact, it was enough to boost the performance YTD relative to their underlying indices to be significantly positive. It looks like they are the beneficiaries of a steep yield curve and perhaps less competition from larger rivals. I have positions in three stocks about which I have written that fall into the category of companies that stand to do well in my opinion: BioMed Realty (NYSE:BMR), Cullen/Frost Bankers (NYSE:CFR) and EZCORP (NASDAQ:EZPW). As I sort through my screens, a number of names come up that appear inexpensive and exhibiting positive relative price momentum.

Financial stocks have fallen hard since peaking at the end of May. The recent low of 23.44 for XLF represented a decline of over 38%, and it has now retraced 75% of the move from the 10/02 bottom to the 5/07 peak. While I believe that many financial companies will struggle for quite some time as they seek to deleverage and improve their portfolio quality, the larger stocks will most likely be “market performers” to slight “outpeformers” for the balance of the year. Some of the smaller ones, with stronger growth potential, steadier capital (deposits, for example) and facing fewer headwinds, could actually perform quite well.

I think that the action this week signaled the start of that trend. Having endured in my career the 1987 crash, the first Gulf War and the recession in 1990-91, the demise of the broker-dealers mentioned above, LTCM and the emerging markets meltdown of 1998, the internet stock and megacap collapse, 9/11, most recent recession, and the second Gulf War, I believe that this too will pass and we will look back on this as a time to have been a buyer rather than a seller. Yes, we will probably make new lows in the S&P 500 (NYSEARCA:SPY) (though not in Financials) later this year – this is just a trade for now. But, rest assured, I will be back advocating buying stocks if that is the way it plays out. I expect, though, that I will be pounding the table at that time.

Disclosure: Long UYG (double-long ETF for XLF), BMR, CFR and EZPW