‘A FOUR-LEGGED BULL MARKET?,’ by Jurrien Timmer, director of investment research at Fidelity.

In Uncategorized on November 11, 2009 at 14:05

The stock market has rallied 65% in about eight months, truly one of the strongest rallies ever recorded. What’s an investor to do? Is there still time to jump in, or is this just a giant sucker’s rally that is about to collapse?


To me, there are four legs holding up this bull:


1. Improving fundamentals: “V-Shaped Recovery”

2. Unprecedented stimulus: “Don’t Fight the Fed”

3. Strong technicals: “Don’t Fight the Tape”

4. Favorable sentiment: “The Rally Everyone Loves to Hate”


While the weight of the evidence suggests that the bull market is still alive, I think the “technical” and maybe even the “sentiment” legs are starting to get a little wobbly. That suggests that we are transitioning from the “straight-up” part of this bull to a more challenging and volatile two-sided market environment.


Let’s take these four legs one at a time.


1. ‘V-Shaped Recovery’

First the fundamentals. The economy shows signs of the beginning of a V-shaped recovery. You can see this in the leading indicators, the Purchasing Managers Surveys, and a host of other indicators such as credit spreads and industrial commodities. And it’s not just the U.S. economy. It’s across the global economic landscape, especially in the Far East. Inventories have been depleted, workers have been laid off, and now orders are returning. That means inventories need to be restocked, which will boost gross domestic product (GDP) growth.


At the same time, a lack of confidence in the economy combined with the high unemployment rate suggests that companies filling orders and rebuilding inventories will initially do so with fewer workers. That means rising profit margins and therefore better earnings growth. We are seeing this in the third quarter earnings reports.


Put strong economic newsflow and strong earnings together and what do you get? A bull market for risk assets like stocks and high-yield bonds. Whether or not this V-shaped inventory cycle turns into a “W” because the consumer isn’t spending is of course a legitimate concern, but one that I think we can worry about later. (V-shaped describes the visual created by charting a severe downturn in the economy followed by a strong upturn in economic activity. W-shaped is where the economy may dip down again in 2010 after the boost from inventory restocking has been realized.) For now, the inventory cycle suggests that we may see several quarters of robust GDP growth.


2. ‘Don’t fight the Fed’

The second leg is the Fed’s “Quantitative Easing” mode. Quantitative Easing is a fancy way of saying “printing money.” The Federal Reserve (Fed) rarely prints money because it is usually fighting inflation, which requires the opposite approach (i.e., raising interest rates and shrinking the money supply). The Fed resorts to money printing when it has to fight deflation, as it is doing now. The problem with deflation is that once the Fed has lowered interest rates to zero, it has run out of ammo. That’s when it starts tinkering with its balance sheet.


The idea is that these “excess reserves” which the Fed has created end up at the banks, and the banks then lend this money out to consumers and businesses. This process then puts what is known as the “money multiplier” to work, and the result is an expanding money supply, more economic growth, and inflation (which in those circumstances is a desired outcome).


However, the money supply is currently not multiplying because the banks aren’t lending. This is called a liquidity trap, and while it is bad for the economy, in a twisted way it is helping the market go higher. Why? Because Quantitative Easing creates an environment that is conducive to risk taking (i.e., speculation). Think about it: The Fed has lowered short-term interest rates to zero and has engineered a very steep yield curve. It’s basically handing out free money for speculators to invest. This is why the dollar has been going down and commodities and stocks going up. They’re all related to each other in what is called the “reflation trade.”


The challenge for the Fed is to reflate just enough but not to over inflate. That, after all, is what happened the last two times the Fed took this approach. An over-easy policy in late 1998 after the collapse of Long-Term Capital Management is considered by many to have been a contributing factor leading to the dot-com bubble in 2000. The monetary response to the collapse of that bubble is considered a contributing factor to the burst of the housing bubble. An endless cycle of bubbles that burst and then get reflated again — it’s why gold has been rallying; it’s hedging against a policy error.


For now at least, Quantitative Easing is a plus for risk assets. While there have been a few rogue Fed hawks calling for it to end, the Federal Open Market Committee (FOMC) press releases have made it clear that the Fed will stay easy for some time. After all, the banks aren’t lending, the unemployment rate is high, and there is a huge wave of mortgage resets happening in 2010.


3. ‘Don’t fight the tape’

The old saying “don’t fight the tape” is very much in force today. Market breadth — the relationship between advancing and declining stocks—has confirmed every new price high for the major averages. Often at price tops there will be a breadth divergence, but this hasn’t happened yet.


Also, the 50-day and 200-day moving averages have still been rising, and every high in the S&P 500 Index  has been higher than the previous high, and every low has been higher than the previous low. These are the very definitions of a bull market.


Furthermore, a massive head and shoulders bottom remains in effect for the S&P 500, triggered by the March low and subsequent rise above 956 last summer. (A head and shoulders bottom is considered a bullish signal because it indicates a possible reversal of the current downtrend into a new uptrend.) This opens up a technical price target of 1,200-1,250, which is still some 150-200 points away.


Finally, we have broad confirmation from high-yield spreads, industrial commodities, and most emerging markets. These markets bottomed early (in December 2008) and have remained strong for the most part.


That said, recent price action has started to look technically “tired.” If the market falls below recent lows, that would interrupt the series of higher lows and higher highs and would be a cause for concern.


Clearly the technicals show that this bull market is maturing. That’s not the end of the world per se, but a potential early warning. The stock market tends to form V bottoms and rounding tops. Perhaps we’re beginning to map out such a top now.


4. ‘The rally everyone loves to hate’

The fourth leg is sentiment. There are just so few signs of bullish capitulation — investors who have not wanted to buy stocks finally caving in and buying at high prices — that it’s hard to imagine a top of importance occurring now. Normally everyone is bullish at the top.


At the March bottom everyone was bearish and no one was bullish. That’s no longer the case. There are very few bears left, but that doesn’t mean that the majority is now bullish. Sentiment in general seems to be “skeptical” for lack of a better word.


Whether you look at sentiment surveys such as the Investors Intelligence or the American Association of Individual Investors, or fund flows, hedge fund leverage, or the general mood among investors and the media, they all more or less reveal the same thing: Investors don’t trust this rally. They either missed it and figure that they are too late to climb aboard, or they are waiting for the other shoe to drop with regard to the economy. While that may be a valid concern, for now it seems to be part of a “wall of worry” that the market likes to climb.


Sentiment has always swung from one extreme to the other. We had one extreme in March, and my sense is that we’ll get to the other one before this rally is over.


The weight of the evidence

The bottom line is that all four legs remain bullish, but they’re not quite as bullish as they were a few months ago. The V-shaped recovery looks good and the Fed should remain easy, but sentiment is not as compelling as it was before, and the technicals are starting to look tired. So, this is no longer the “just close your eyes and buy” market that it was in the spring and summer. It‘s a more challenging and tactical environment in which there is still upside potential but also more downside risks.


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