The weight of the evidence suggests that an important intermediate-term bottom was put in on March 6, when banking system insolvency fears peaked, and the S&P 500 plunged to 670, a 13-year low. Apart from the sheer magnitude of the bear market declines in broad stock indexes (60%!) over the past 18 months, which have discounted a tremendous amount of “bad news,” sentiment indicators issued a strong contrary opinion buy signal in early March.
The American Association of Individual Investors survey registered the most bearish reading in its 22-year history a month ago; 70% of respondents were bearish in their 6-month stock market outlook, while only 19% were bullish. The immensity of the government’s stimulus efforts, both fiscal and monetary, which now total a mind-boggling $4 trillion, appear to be taking hold in the economy and markets.
As a percentage of GDP, this figure - which represents the sum of actual and proposed deficit spending and Fed balance sheet expansion to battle the forces of recession and private sector debt deflation - is three times what the U.S. government spent in the 1930s to battle the Great Depression! Inevitably, government stimulus of this magnitude is going to have an effect on asset prices and economic activity.
In addition to the firming that has occurred in stock and commodity prices, evidence has emerged that the economy is stabilizing. According to the latest leading economic indicators from the Economic Cycle Research Institute, the pace of economic contraction will ease in the coming months, implying that we are getting through the worst part of the recession. Even the most adverse periods in economic and financial market history (e.g. the 1930s and 1970s) have intervals of reprieve, accompanied by multi-month rallies in risk assets.
Our sense is that we have entered such a period, and that this rally will have significantly more staying power than the respite from the selling that occurred at the end of 2008. Stocks are quite overbought in the short term, however, so markets will likely spend several weeks consolidating or correcting recent moves. Now would be a natural time for such a consolidation or correction to begin, given that the 26% gain we have seen over the past four weeks in the S&P 500 almost precisely matched the 27% rally in the S&P 500 from November 21 to January 6. A reasonable technical and fundamental price objective for the S&P 500 over the course of a multi-month advance is 950 to 1000.
Stocks, both in the U.S. and abroad, are very cheap from a historical perspective, but the economic problems are daunting. This argues for a neutral (and patient) allocation to stocks in a longer term asset allocation context.
The economy seems to be in the process of stabilizing from the free-fall that began last September, and will likely spend an extended period at approximately the current level of economic activity, propped up by massive government intervention and stimulus, and simultaneously weighed down by private sector balance sheet rehabilitation, which will involve a multi-year process of higher savings and debt reduction.
There is a strong case to be made for a healthy allocation to foreign stocks in an equity portfolio: they are cheaper than U.S stocks; key emerging markets (e.g. China and Brazil) have superior growth prospects; a number of foreign economies (both developed and emerging) have fewer problems with banking and debt; finally, there are reasons to be concerned about the U.S. dollar over a secular time frame.