Tuesday, November 25, 2008

Bear Market Rally?

Before we are all swept away into total despair, let's take a step back and imagine what could get stocks round the world going up for a while.

First, let me point out that by definition the bottom of a bear market has to be the point of maximum bearishness. Thus sentiment becomes a crucial indicator. The systematic work that we do on measuring sentiment (and we monitor about 20 indicators for the US and a dozen or so for other equity markets) show very extreme and in many cases record levels of bearishness.

Second, valuations are cheap. There's no point in going into an elaborate dissertation; it's an inexact science. Using the best historic measures, normalised earnings, book value, and free cash flow, stocks are very cheap, but not as cheap in absolute terms or versus interest rates as they were in the 1930s or at the 1974 bottom. Nevertheless, the 4 per cent dividend return on the S&P 500 exceeds the yield on the 10 and 30-year Treasury bonds for the first time in 50 years. If emerging market equities, where the growth is, at six to eight times earnings are not cheap I don't know what is.

Third, stock markets have been obliterated and are deeply oversold. Even dead cats bounce. The Dow has had the steepest decline since the 1930s, and the spread between the price and the 200-day moving average at 34 per cent is the greatest since July 19, 1932. The US market is down almost 50 per cent from its highs, Europe is off 55 per cent, and emerging markets 65 per cent with some unfortunates, such as Russia, off 70 per cent. History shows that even in enduring, secular bear markets there are not just 20 per cent bounces but usually one 30-50 per cent rally. We should be due.

If I'm bullish why am I not in there now? Because I would like to see the credit markets unclog and spreads come in more. At the bottom of a panic, the news doesn't have to be good for stocks to rally, it just has to be less bad than what has already been discounted. I want the markets to stop going down on bad corporate and macro-economic news.

The fact that it still does shows the bad news has not yet been fully discounted. I have no idea when the next bull market starts, but I do think we are setting up for the mother of all bear market rallies.

-- by Barton Biggs [via veryearly1]

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