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Anatomy of a Rally: Where Analysts Failed

Although the inception of another bull market has been the favorite subject of analysts and commentators since the end of March this year, even the most optimistic analysts were unable to predict the scope, size, or favored sectors of the market rally, according to an article by the Bloomberg news agency. Some of the more famous and respected financial advisors working for such firms as Citigroup, Bank of America, and a number of other reputable banks and financial firms advised clients to purchase the shares of European energy producers and American drug makers, while selling banks and retailers at the beginning phase of the rally. Yet the stock market rally has favored the most negatively-rated companies, and those who followed the advice of analysts did not acquire enviable returns on their investment decisions.

The rally continuing since March 2009 has been fueled and sustained by gains in the shares of some of the most fragile sectors of the economy. Retailers, construction companies, banks, including some of the cheapest and most battered firms have been making the greatest gains, apparently confounding analysts and all those who were expecting a long-term decline in the profitability of companies that made the worst mistakes in the past years.

Yet, as noted by Romain Boscher, who is part of the team overseeing Groupana Asset Management in Paris, the analysts failed mostly because they were attaching too much importance to fundamentals, while ignoring the great emotional momentum created by the urge to buy companies at the brink of bankruptcy, and cash in on the gigantic returns which will be generated if the economy comes back to life in the way envisioned by Mr. Bernanke and his followers. It is little more than a gamble based on the premise that the global efforts of governments will somehow be able to resurrect the cycle that got many thousands rich in the past decade, while crushing millions as it unraveled. Will this gamble play out well for those who take it? Only time will tell, but we do not think that it will.

The main characteristic of bear markets, as we all know, is volatility. If bear markets were not so volatile, trading them would be no different from trading bull markets, and profit making would be equally easy. Yet, as traders know, bear markets are very different from bull markets: bull markets cause volatility to fall, and as prices rise, corrections are usually tame and of limited depth and duration. In bear markets, however, there is no expectation of a smooth fall in prices. On the contrary, there are many powerful, long-lasting, and deep bull phases where people bet on the end of the bear, pile in on crowded trades, and get burnt out as their dreams are foiled by realities. Bear-rallies are fueled by emotions, not fundamentals, and those who try to understand them on that basis are unlikely to achieve very positive results. As such, our own bull-phase lasting for six months or even longer, by no means negates the picture of a bear market, as demonstrated with overwhelming evidence by the decades-long experience of the Japanese stock market.

What many commentators and analysts fail to recognize, in our view, is that the dollar-bearish case has already played itself out for the most part. The Federal Reserve did all that it could to perpetuate the asset bubbles (in the stock market and elsewhere) by debasing the dollar as much as it could in the past nine years or so, and we are going through this economic downturn only because the market refused to respond to ever greater dollar showers in the way it used to do. The Fed’s response to the present crisis has been supplying more of the same in ever greater dollar emissions, and there is little sense in the expectation that what caused the crisis will also be its remedy. The stock market may have a ball in the meantime, and those who want to play chance games may join the bonanza, but the underlying economic picture remains the same, and in the absence of a major inflationary episode, the long-term bear market may run for years to come.