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Hans retired from his business career at 55 and pursued his passion to help others achieve financial independence. A graduate of the US Air Force Academy with an MBA majoring in Finance from the University of Colorado, Hans continued to invest throughout his career in the US Air Force, Bank of... More
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  • Is it a Bull or Bear Market – Case for a Bear Market Rally 4 comments
    Sep 13, 2009 04:04 PM
    Are we in a bull or bear market? That is the question many are asking with the S&P 500 up 50% from its March 9th low. Whether we are in a new bull market or just experiencing another bear market rally is important for investors to answer. Today, I will present the case for a bear market rally. In the next few days, I will offer why the bear market is over.
     
    In early 2009, the economy looked over the precipice and saw a deep depression looming. The market entered a bear market that plunged to significant lows. Since then the market has rebounded rising 50% from its low of 666 on the S&P 500 in early March Is this move up by the market a new bull market or a bear market rally?
     
    Whether we are in a new bull market or experiencing a bear market rally depends on your view of some important economic factors including the state of consumer spending, the role of the financial sector in the market, the valuation of the S&P 500 and investors’ appetite for risk.
    Consumer Unable to Spend as Before
    So far, the consumer has not returned to their free spending ways even after the government stimulus. After having seen their savings disappear, many people are putting their extra money into savings. While the higher savings rate does not help the GDP expand in the short term, it does provide a stronger capital base, a positive for the long-term health of the economy. A new bull market needs to see consumer spending return to help push up the GDP of the U.S. Without consumer spending, we are more likely to be experiencing a bear market rally.
     
    Since the credit market was the major contributor to the collapse of the housing market, we need to start our review there. A study by Atif Mian and Amir Sufi of the University of Chicago’s Booth School of Business found that house prices and household debt increased most where the supply of new housing was limited. In places where there was limited space to build, prices rose more, bring with it, more borrowing. On the other hand, in cities where homes can easily be built to meet demand as there is plenty of space, the prices did not rise, and debt barely rose.
     
    To understand the connection of home price values and debt, the researchers limited their sample to those who were homeowners in 1997, before the boom in housing and credit. This allowed them to measure how much of the rise in debt was the result of cashing in on higher home values. They concluded that almost 60% of the increased debt between 2002 and 2006 came from homeowners cashing in on their higher home values. The authors estimate that almost all of the $1.45 trillion that was borrowed against rising home equity was used for spending.
     
    An even more worrisome finding from the study was borrowers in the lowest quartile of creditworthiness borrowed more readily. Between 2006 and 2008, more than a third of the loan defaults were due to home-equity based borrowing. This suggests the consumer will not be able to return to their former levels of spending, as they cannot depend on rising home equity values to fund their spending. Without growing contribution from the consumer to the economy, GDP will not grow as expected. This causes us to face a bear market rally rather than a new bull market.
    The Financial Sector’s Rebound is from an Artificial Low
    The financial sector is an important component of the stock market. In the market meltdown early 2009, the financials plunged as investors feared many banks would fail much like Lehman Brothers. Once some confidence returned in March, the financials led the rebound in the market. This has caused some investors to believe a new bull market is underway.
     
    However, the rebound by the financials is not sustainable as new credit problems still exist. Foreclosures are still rising and the commercial real estate market is rapidly becoming a major problem. The market overreacted to the financial sector to the down side and now it is doing the same on the upside. The rebound by the financials overstates the strength of the recover by the market. Any weakness in the financial sector will negatively affect the market. This is a classic indication of a bear market rally, not a new bull market.
    S&P 500 is Overvalued
    S&P 500 is trading at 27.5 times the consensus estimate of 2010 earnings. The historical average is about 15. With 99% of all companies reporting, Standard & Poor’s is reporting that based on “as reported earnings” the trailing PE ratio for the S&P 500 is over 130 based on a closing price of 1,025. A PE ratio this high does not give any room for the market to rise.
     
    Moreover, companies have improved their bottom line performance by cutting costs not increasing revenues. Any time the PE ratio is so high we should expect more downward pressure on the market.
     
    As a result, we are looking at another indication the recent rise in the market is just a bear market rally and not a new bull market.
    Savvy Investors Reducing Risk
    Investors who manage large funds understand that loss of capital is of utmost concern. As astute investors, they seek ways to lower their risk, especially after experiencing a nice run up in the value of the portfolios they manage.
     
    Recently, the demand for low risk Treasures is climbing as yields are falling, indicating there are more than enough buyers for these bonds. Besides China, investors are buying Treasuries to lower their risk profile of their portfolios. If these investors expected the rally to continue, you would see them reducing their holdings of Treasuries as they sought to generate returns to match the market.
     
    Speaking of large investors, according to Trim Tabs Research, in July hedge funds lost $26.2 billion in fund out flows. If this were a new bull market, they would be adding money into these funds.
     
    In addition, companies are no longer buying back their own stock. Instead, they are selling more than 6 times as many shares as they are buying. Trim Tabs reports that stock sales by insiders rose to $6.1 billion in August, while insiders only bought $160 million of their own company’s stock, a 38:1 ratio. According to Thompson Financial, readings below 12:1 are bullish and over 20:1 are bearish. Though to be fair, Thompson Financial is reporting that the insiders’ transactions ratio is slightly above 12:1. One measures value of shares, while the measures number of shares sold or purchased.
     
    When managers of large funds reduce their holding of stock on the belief the rally might be ending, it is another indication that we are in a bear market rally and not a new bull market.
    The Bottom Line
    These factors indicate the market rally is more likely to end soon, rather than continue. The question whether we are in a new bull market or a bear market rally favors the latter. Bull markets need to see growing evidence that the economy has underlying strength and that the financial sector can continue to be a leader. The high valuation, as the PE ratio shows, gives little room for further expansion other than through growth in earnings. Moreover, the high valuation increases the risk of a pull back in the markets. Finally, perceptive investors are reducing their risk profile of their portfolios taking money out of the market.
     
    As indicated, we are experiencing a bear market rally that will end soon. While the market can climb a wall of worries, these fundamental factors tell us a new bull market is not in the cards, rather we will soon see a bear market rally.
     
     
    Themes: bear market rally
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This post has 4 comments:

  •  
    Hans, How can you call a 54%+ rally a "bear market" rally? Are you expecting that we will retest and break through the March 9th low? This has now exceeded the 1929 rally and this is certainly no depression.
    dshort.com/charts/bear...
    I don't think the market is undervalued but is not over valued either. Where you got your forward p/e of 27.5 from? WSJ is reporting 17.38.
    online.wsj.com/mdc/pub...
    Anyway long term technical's are still favouring the continuation of the rally. S&P 500 is well above both 200 and 50 dma with the latter having crossed the former in July (golden cross). The Coppock guide is signaling a strong "buy".
    seekingalpha.com/insta...
    You say that "savvy investors" are reducing risk! Where is the evidence? They never got in and now are getting desperate for a correction so that they get psychological cover to get into the market again.
    With all due respect, I just don't believe in arguing with a rally - the market will tell me when to get out, when the indicators start to fade.
    Sep 14 12:40 AM | Link | Reply
  •  
    With this recessions rally being the biggest gainer to date and with all the head winds our economy will be facing how much higher can it go, is it worth the risk to risk what one has already made for how much more gain? is it worth the risk to invest new money? Technicals are great but are they so good that one can just leave it to the charts to tell you everything you need to know, You said " when the indicators start to fade" when do you know if a "fade" is real or not? one you should act on? If technicals was all one needed to follow wouldnt the so called smart money people not have lost what they had during the past two corrections? Wouldn't the hedge funds have see what was coming and prepared instead of getting caught off guard as they all did. Wouldnt the Government have seen what was coming and started to prepare for it? Why was it that it seemed everybody including the Oracle of Omaha got caught with their pants down?

    BTW- you indicate the savvy investors never got in this rally, I say the retail investor is not the savvy investor, they are not the smart money, they are the pawns needed to end this rally cycle, for the market to really find its top during which the savvy investors will begin their exit strategy.


    n Sep 14 12:40 AM E Nuff Sed wrote:

    > Hans, How can you call a 54%+ rally a "bear market" rally? Are you
    > expecting that we will retest and break through the March 9th low?
    > This has now exceeded the 1929 rally and this is certainly no depression.
    >
    > dshort.com/charts/bear...
    > I don't think the market is undervalued but is not over valued either.
    > Where you got your forward p/e of 27.5 from? WSJ is reporting 17.38.
    >
    > online.wsj.com/mdc/pub...
    >
    > Anyway long term technical's are still favouring the continuation
    > of the rally. S&P 500 is well above both 200 and 50 dma with
    > the latter having crossed the former in July (golden cross). The
    > Coppock guide is signaling a strong "buy".
    > seekingalpha.com/insta...
    >
    > You say that "savvy investors" are reducing risk! Where is the evidence?
    > They never got in and now are getting desperate for a correction
    > so that they get psychological cover to get into the market again.
    >
    > With all due respect, I just don't believe in arguing with a rally
    > - the market will tell me when to get out, when the indicators start
    > to fade.
    Sep 14 08:20 AM | Link | Reply
  •  
    Good point. I am a recent convert to long term technical indicators having stayed full invested through both the down leg and up leg of this bear.

    However a savvy user of technical indicator could have seen the bear market coming in the distance (though not many forsaw the sheer fury).

    Both the 50-200 dma cross-over and the Coppock guide gave a clear "sell" signal in the winter on 2007-2008. Both these indicators gave a clear buy signal in June and May 2009 respectively.

    While a 10- 15% correction is likely, I think we are now in a cyclical bull market with a secular bear which started in 2000.
    Sep 14 05:47 PM | Link | Reply
  •  
    The point of the article was to make a fundamental case for a bear market rally. Regarding the 27.5 PE ratio, I suggest reading my latest article on the PE ratio for the S&P 500. The trailing PE ratio is 122 and the forward PE is 25.28 with a forecast for the next year's earnings of $41.49. The earnings forecast is from Standard & Poor's.
    There are several technical indicators that say we are near a high with a pull back likely. Then others tell us the rally will continue. My view from a techncial standpoint is we are still in a nice rally that shows signs of aging but has not turned down. The only problem I see longer term is the fundamentals do not support a strong recovery in the eocnomy, so I do nto expect the market to move up much more. Sideways trading is more likely
    Sep 14 06:34 PM | Link | Reply
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