Business Times - 03 Jun 2009By PRADEEP VERMA
SINCE the equity markets bottomed on March 9, I have always been very careful to point out that the current rally is a bear market rally. In other words, I believe that the current intermediate uptrend will be viewed as a counter-trend rally within an ongoing bear market. The US economy is still deteriorating, unemployment is rising, housing is weakening and another global pandemic may be spreading across the world.
However, despite all this alarming news, stocks aren't falling apart. I'd say this is due to the fact that investors had already forecast a total failure of the banking system last autumn. And when the worst-case scenario didn't materialise, investors' risk appetite returned and they've been snapping up quality stocks at these depressed prices. It is my firm belief that the market discounted another 'Great Depression' last autumn when we witnessed forced liquidation of all assets. Since then, the financial markets have been building a base and I suspect the bear-market low is now behind us.
Since its low at 677 on March 9, the S&P 500 has climbed closer to the magic 935 number. The index closed at 929 on May 8. That's a 37 per cent gain from the March 9 low and just six points shy of where it was on Jan 6, 2009. Why would that be important? Because bear markets don't sketch out a steady pattern of lower and lower prices. They're punctuated by major rallies, such as the one that began at the Nov 20, 2008 low of 752 and then failed at 935 in January 2009. But in a bear market, each rally does fail and then - and this is the defining characteristic of a bear market - stocks fall to a low that's even lower than the one before.
A rally that broke through the January 2009 high at 935 would disrupt that pattern and give investors confidence that the next time the stock market retreated, it would end that correction above the March 9 low. That combination of a higher high and a higher low would mean that the bear market had indeed ended and that stocks had moved into another bull market.
Personally, I doubt that the rally will break through the January 2009 high of 935. If we look back at the last bear market, the S&P 500 had three important lows in July 2002, October 2002 and March 2003 (see chart). The lowest low happened in October 2002, so according to the basic definition of a bull market, that was the beginning. The next stop was the December 2002 high and a two-month gain of 24 per cent.But the Relative Strength Index (RSI) indicator made a higher low in October 2002 than it did in July 2002 to set up a very bullish divergence between the two. Combine that with the huge rally off the lows and it did indeed look very promising for the bulls. Fast forward to today and we do not see that bullish divergence. Therefore, I am of the view that the market will once again try its March 9, 2009 low.
Another weakness in the current market rally is that volume has always been suspect. Traditionally, a market rally would start slowly and then grow as more participants believed they could put their hard-earned money to work to earn a rate of return greater than money market funds or other competing assets. As the rally progresses, more investors become desirous of investing and volume begins to swell.
That has not happened this time around, just as it hadn't during the past few bear market rallies. As a matter of fact, most of the high volume days came when the markets were down. This is not a sign of a healthy market rally.
This rally has also been classified by many experts as a junk rally. This occurs when the riskiest asset classes significantly outperform quality investments - small cap outperforming large cap, high-yield bonds gaining more than investment-grade bonds, high- volatility stocks performing better than low-volatility stocks, or risky sectors like financials and consumer cyclicals shining better than defensive sectors, etc.
Many bulls have seen this rally as a result of the 'green shoots' that US Federal Reserve chairman Ben Bernanke proclaimed during a speech in March. These economic reports show that the economy is no longer in a free fall that essentially ground business to a halt during the fourth quarter of 2008. Who are we kidding? Growth is the major driver when it comes to corporate earnings and we are clearly not in a growth phase, nor does it appear that we will see any significant and actual growth for several quarters to come. However, we wish and hope for better days. Back-to-back gross domestic product (GDP) numbers showing a contraction of more than 6 per cent are no reason to rejoice, even if the economy is assumed to stabilise by Q4 2009.
There are also macroeconomic concerns in play that are being discounted. One of the most important is the disturbing level of unemployment and the realisation it is going to climb for some time to come. Banks are still not lending - and who can blame them? As the Case-Shiller 20 index shows, prices for the average house continue to decline alarmingly. Most economists agree the first thing that needs to be done is to fix the US housing problem, as that is key to correcting the problems within the financial sector.
Moreover, another historical marker of secular bear markets is value indicator. Historically, the dividend yield will be roughly equal to the price-earnings ratio at secular bear market bottoms. At the 1932 bear market bottom, the yield was 10.50 per cent and the P/E was just under 10. At the 1942 bear market bottom, the yield was 8.71 per cent and the P/E was 7.3. At the next great bear market bottom in 1974, the yield was 5.9 per cent with a P/E of 7.24. If we take this same reading at the 1982 low, the yield was 6.2 per cent and the P/E was 6.9.
Presently, the yield on the S&P is at 2.62 and the P/E sits at 59. Yes, I know that many of the analysts show the P/E on the S&P to be in the 15-20 range. Those numbers are based on the so-called 'operating price earnings'. The P/E based on Generally Accepted Accounting Principles is 59 and that is the same measure as has been used throughout history. In any event, even based on the market P/E of 15-20, it is safe to say that the P/E and the dividend yield are nowhere near par. As a result, this data also suggests that the March low was not the bear market bottom.
So, whether I look at the technicals, stock volumes, the historical relationships between bull and bear markets or the historical measures of dividend yield to PE, the data all points to the same conclusion: the bear market isn't over. This is a bear market rally and the longer it lasts, the more people it will suck in and crush in the end. That is, after all, what bear markets do.
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