Investors are getting very
nervous about the durability of this rally,
or Monster Rally in a secular bear market,
or cyclical bull market, etc. Whatever you
want to call it, it’s up a lot from the
March lows – 50%+ for the S&P 500 and the
Dow, 100% median return for all U.S.
equities and more for many emerging
markets. Much to the amazement of all of
us, most risk markets have pretty much
normalized in this very compressed
timeframe. Credit spreads have contracted
to a level just above their long term
averages from record high levels in the
first quarter. The VIX, a measure of stock
market volatility, has also collapsed to a
level suggesting a normalization of equity
investor anxiety. Finally, investor
sentiment has totally reversed from extreme
pessimism to something just shy of euphoria.
Chart I
Investor Sentiment

Source: Ned Davis Research
This magnitude of a move
should give us all some pause. So, let’s
take a look at some history.
The Leuthold Group has
recently examined all bear market recoveries
since 1900. The current one is the 23rd.
The median return of the DJIA or the S&P 500
since 1926 for the prior 22 was +84% and
lasted an average of 32.5 months.
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.