They then did something very interesting.  They segmented these bull markets into two groups, those whose preceding bear market decline was -45% or more and those with a lesser decline.  We all know that this past bear market was brutal and exceeded all others in pain level with the exception of the -86% plunge in the 1929-1932 Great Crash.  That one we all read about and reflected on how terrible it must have been for our parents and grandparents.  This one was very personal.  The S&P 500 declined -57% from October 9, 2008 and lasted 17 months.  This horrible experience approximated the -54% median drop in the prior nine severe bear markets (returns worse than -45%).

 

Now for the cyclical bull market recoveries.  They all have one thing in common – the vast percentage of their move off the bottom occurred in the first year or two.  Two years after their cyclical lows, the average return of the nine bull markets following the most severe declines was +70%, which was not much more than the +63% after one year.  The two year returns ranged from +44% (three times) to +124% following the `29-`32 crash.  We can throw out that outlier by looking at the median gain for the nine experiences which was +63%.

 

Table I

Bear Market Declines of 45% or More

Source:  Leuthold Group

 

This pop off the March 9 bottom seems right out of the historical playbook.  As we mentioned above, the major indexes are up 50%+ and the average return for all stocks was twice that.  The only difference is the Monster Rally has been compressed into 7+ months, much faster than the typical cyclical bull.  Leuthold has conveniently presented this factoid for us graphically: 

 

Chart II

Upside Still Suggested For S&P 500,

But The “Too Far—Too Fast” Crowd Might Have It Right This Time

Source:  Leuthold Group

 

This “too far, too fast” phenomenon is the crux of the concerns of the sweaty hands crowd.  At best, they say, the market is due for a pause.  At worst, it could be painful.  As the title of the chart suggests, they just might have it right.

 

The nervous crowd seems to be divided into two distinct camps: 

 

1)  The first group of bears would embrace a recent article in the Financial Times suggesting that the Fed’s public statement following its upcoming November meetings might very well be more hawkish than their releases over the past year.  In other words, they opine that the Fed may drop the words “extended period” from the Committee “continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period” in their most recent statements (italics are ours). 

 

If one examines the most recent tightening cycle which began in 2004, there are reasons for concern.  In January of that year, the Fed changed its dovish language to something suggesting that there was a point down the road when they would move to a less accommodative policy.  Investors took that seriously, and the market started its sideways-to-down pattern, a full five months prior to the Fed’s first hike in rates.   

 

Chart III

Source:  ISI Group

 

That had never happened before.  Prior to that, the market always peaked coincidentally with the removal of the punchbowl.  Our guess is that the market’s reaction to the next signal of a policy change will more likely mimic the 2004 experience, given the increasingly anticipatory nature of all markets today.

 

That leaves us to guess what the Fed will see and when it will signal that the economic and systemic risks have abated.  The subtlety of all this is, for sure, not lost on the Fed.  The last thing it wants or can afford to do is to abort this fragile recovery.  And higher asset prices and higher net worths are integral to achieving and sustaining economic growth. 

 

The Fed’s and Obama’s economic teams are populated with deflation experts.  It’s difficult to imagine that the fears which drove them to implement the extreme, unprecedented policy moves have abated to the point where they will reverse those same moves soon.  The economy just bottomed in the third quarter and unemployment is still rising.  And it will continue to rise, most likely through the first half of next year.  Typically, the tightening cycle did not begin until the unemployment rate turned down.  Our guess is that this time will most likely be no different.  But maybe they might signal it before then – that’s probably the time when the party-goers will head for the exits. 

 

Will the Fed worry about asset bubbles this time?  Of course it will.  However, it’s hard for us to appreciate the arguments of those who think U.S. equities have entered bubble territory.  At 15 x normalized earnings and with profits, cash flow and free cash flow all very robust, we’re a long way from nosebleed market levels.  The price/sales ratio is a good valuation metric when profits are depressed.  And current readings, while not at bargain levels, suggest the market’s valuation is no higher than average. 

 

Chart IV

S&P 400 Price/Sales

Source:  Ned Davis Research

 

More importantly, the value of the consumers’ most important asset – her house – remains depressed.  Yes, there are encouraging signs that the residential real estate market might be bottoming.  But come on – how can there be anything approaching a bubble when so many homeowners are saddled with negative equity and prices are off -5% -to-50%, depending on where you live.  And let’s not forget that credit remains scarce or unavailable to many borrowers.

 

Consumer net worth has taken a huge hit even after this +50% market rally since stocks are still down -30% from their peak.  And it’s only back to where it was in 2004.  Consequently, balance sheets remain fragile and must be repaired.  That doesn’t happen when rates are rising.  So, it won’t happen for awhile.  And that’s why the Fed has to be very careful about what it says and when it says it.

Chart V

Consumer Net Worth - ISI

S

source:  ISI Group

 

2)  The second group of bears fears the double dip.  They believe that whatever economic recovery we’re enjoying currently is largely the result of monetary and fiscal policy stimulus.  They feel that in the absence of further stimulus, there’s not enough private sector momentum to generate a sustained recovery.  So, they think that there’s a reasonable chance that the economy will flatten out after the first quarter of 2010 at best or, more likely, slip back into recession.

 

That would be a most unfortunate outcome.  Among other things, the very impressive profit recovery which we discussed in our last letter would then be robbed of the necessary next stage of growth which requires revenue gains.  Without them, the fundamental underpinnings of the equity market would fail to materialize, leaving stocks vulnerable.  More importantly, the fragility of the credit markets would be exposed as losses escalate on debt and credit spreads widen anew.  And what about unemployment?

 

Our political class is painfully aware of this possibility and what it would mean for their bottom line – re-election.  Charlie Cook, the astute political observer who publishes The Cook Report, recently opined that there’s a 50/50 chance the Republicans retake the House in 2010.  Hard to believe, but the Administration and the Congressional majority aren’t dismissive of that possibility.  The world is dynamic – not static.  People – even politicians – react when they believe there’s a high probability that a future event will have a major impact on their self interest.  And Washington will react this time.  They will throw as much policy stimulus as they think is necessary, regardless of how bad it might be.  And a lot of it’s likely to be bad.  No doubt, the deficit outlook will worsen.  To the extent that there’s an attempt to reduce the deficit, it will most likely be via the tax route, i.e. higher levies.  That’s never good for economic growth.  Clearly, we’re very concerned about bad policy and its impact on the economy and markets.  But that’s a story for another day.

 

While we don’t rule out Scenario 1, we think the risks of poor economic performance are greater.  The bigger immediate concern is deflation, not inflation.  The latter may be the ultimate outcome, but it’s our view that scenario won’t materialize for at least several years.

 

What makes sense now?  Inflation is low, the economy is recovering and liquidity is abundant, actually more than abundant, i.e. the risk asset markets’ sweet spot.  This confluence of virtuous financial and economic conditions is what has been driving stock, corporate bond, oil and gold prices higher while the dollar weakens against most freely floating currencies.

 

We’ve felt that liquidity – either in abundance or absence – is the primary driver of market cycles, both up and down.  Liquidity couldn’t be more plentiful at the moment.  And that’s not going to change for the foreseeable future.  The global monetary system continues to be driven by the same imbalances – too much U.S. spending and too much emerging market savings.  Consequently, the U.S. current account deficit, while down about 40%, is still large and must be recycled back into global capital markets.  This ensures that long term interest rates will remain below equilibrium levels and risk asset prices elevated.  As we indicated above, Fed policy will remain accommodative for as long as it takes.  There’s little doubt that the Fed Funds rate will stay abnormally low until consumer net worth has recovered further and that the risks of an economic double dip have abated.

 

The most powerful phase of a cyclical bull market is when the economy is in the depth of a recession and the Fed has moved into an accommodative monetary phase.  Seems counter-intuitive.  But it’s not. 

 

 

Chart VI

Source:  BCA Research

 

This is the phase when liquidity is expanding most rapidly – private credit demands are collapsing while the Fed is pushing out maximum monetary policy stimulus.  Moreover, stocks are very cheap, particularly following severe bear markets like this past one.  Leuthold’s work described above makes this point emphatically.

 

But we’re past this period.  Stocks are up huge and the economy is beginning to grow again.  The liquidity is still there but the skepticism isn’t.  At best, we’re only 50-60% through the bull cycle.  However, Leuthold’s work would indicate we’re closer to 80% through it, which might give us another +20-25% before this cyclical bull market expires.  We think the powerful liquidity tailwind is likely to get us there.  For now, stay the course.