The lesson of history is that you do not get a sustained economic recovery as long as the financial system is in crisis.
—Ben Bernanke
While vocally bearish in 2007–2008, I changed my ursine view in the first week of March 2009, when, on CNBC and in pages of the Wall Street Journal, Bloomberg, and, of course, TheStreet, I called for a “generational bottom” for the U.S. stock market.
In this chapter, I explain the metrics I observed to make the call that we will never again see the S&P 500 sell at 666 in our lifetimes—a call I still believe in.
It is important to recognize, however, that the domestic economic recovery has been lopsided. A top-heavy and uneven recovery, induced by monetary policy's heavy hand of inflating asset prices and balance sheet wealth, has failed to promote real income growth and holds the potential for social, political and other risks never seen in our lifetime.
While monetary policy has been good for Wall Street, it has not trickled down to the benefit of Main Street. Consequently, the future remains uncertain and, in the fullness of time, possibly problematic to stock valuations down the road.
Finally, after a near trebling in the S&P 500, I advise why we should never lose sight that genius is a rising market and that in a bull market, it is often indistinguishable between being lucky and being smart.
“It is like a grain of mustard seed, which a man took, and cast into his garden; and it grew, and waxed a great tree; and the fowls of the air lodged in the branches of it.”
—Luke 13:18–19
Larry Kudlow is fond of bringing the financial world's attention to the mustard seed parable, which, in a religious context, is often interpreted as being a prediction of Christianity's growth around the world. Jesus compares the kingdom of heaven to a mustard seed. The parable is that mustard is the least among seed, yet grows to become a huge mustard plant that provides shelter for many birds.
In an economic context, Larry believes the mustard seed parable has some merit, as the “shock and awe” from the recent policy moves geared toward stimulating the economy could sow some good economic results in 2009. Given the painful market action over the past six months and the extremely negative sentiment, which seems almost antithetical to investors' enthusiasm a year ago, Larry feels a rich investment harvest might be reaped.
While Larry's optimism has some virtue, I have argued that we are not in a garden-variety business/market cycle, as the wealth destruction of lower home and stock prices will retard growth—similar to the notion held by some religious scholars that the birds in the mustard seed parable represent an undesirable presence capable of eating up any new seeds the farmer sows in his field and preventing the trees (Christianity and the stock market) from bearing fruit.
Moreover, I have opined that it is hard to have conviction until:
I recognize that my concerns, which are currently weighing on our credit and investment markets and on the world's real economies, have now been fully embraced by the media and by nearly every investor and strategist and that, to some degree, stocks have reflected the gross economic and credit realities. This is in marked contrast with conditions a year, six months, or even three months ago, when I saw a plethora of short opportunities framed in a variant and negative view.
Time and (lower stock) prices cure all, so even before credit improves, hedge fund redemptions decelerate, and signs emerge that the current forceful policy measures are remedying the downside economic spiral and an engaged President-elect surrounded by an experienced and intellectually gifted corps of advisers enacts his own policies, the market's downside influences could recede as stock prices might advance well before the all-clear economic signal is embraced.
Given the above, my investment blueprint over the next several months is taking a more positive tint. We seem to be moving toward the following paradox:
I have concluded that we have likely seen the year's lows, but the harder issue is trying to define the slope of the recovery in stocks. Given the headwinds (especially in credit), it should be frustratingly modest at first—we still seem to be in a very broad trading range—but the trajectory will hopefully gain steam as the year progresses and clarity regarding the depth/duration of the recession develops, the hedge fund redemption issue is left behind us and stocks increasingly react more positively to bad news.
Already some of Larry's mustard seeds are being ignored. For instance, take a look at housing, in which a combination of targeted and aggressive policy efforts aimed at reviving this beaten down sector of the economy, a marked reduction in home mortgage rates, better affordability and an extended period of low production of new homes (vis-à-vis population and household formation growth) argue that the balance between housing supply and demand might move closer in balance earlier than expected.
In conclusion, I am not yet in a rush to buy aggressively, but I am increasingly confident that investments made in the next three to six months will look terrific one to two years from now.
I am also convinced that the current negative groupthink on the part of the hedge fund community (and others), which is manifest by their current low invested positions amid fear of further investment losses and additional redemptions, will cause them to miss the bulk of the early advance in equities when it comes. As such, the potential is for hedge funds to become the new marginal buyer that is capable of extending the market's initial gains in 2009.
Shopping lists should now be made for both holiday gifts and for stocks, as they are both being discounted.
I am a realist. We are in difficult and challenging times.
I have learned over the course of my investment career that the quest for delivering superior investment performance has grown more complicated, as it is accompanied by demands for permanent flexibility, a more balanced view and, usually, a less extreme portfolio construction. I am also of the belief that neither Pollyannas nor Cassandras are stock market moneymakers; they are, more typically, only attention getters.
While I fully recognize that the road back to economic growth and stock market repair will not be orderly—it will be filled with potholes and detours—a number of factors are now conspiring to improve the chances for business stability and for a recovery in the equity markets.
From my perch, some of these include:
With so many extreme sentiment readings (and a steepening in the price and yield declines) in commodities and fixed income, coupled with more substantive/coherent policy measures (and a more engaged leadership) and a market that has begun to respond more positively to bad news, an important change in stock market conditions could be imminent just when most investors have turned to the sidelines.
Color me more bullish, as it is my view that in the fullness of time, policy, sentiment, and value will trump corporate profit and credit issues.
“I hate to say this, but this place is getting to me. I think I'm getting the Fear.”
—Dr. Gonzo in Hunter S. Thompson's Fear and Loathing in Las Vegas
Though initially criticized, Hunter S. Thompson's Fear and Loathing in Las Vegas has become required reading for students of American literature. Rolling Stone magazine's literary critic, Mikal Gilmore, wrote that the book “peers into the best and worst mysteries of the American heart” and that the author “sought to understand how the American dream had turned a gun on itself.” The critic went on to write that “the fear and loathing Hunter S. Thompson was writing about—a dread of both interior demons and the psychic landscape of the nation around him—wasn't merely his own; he was also giving voice to the mind-set of a generation that had held high ideals and was now crashing hard against the walls of American reality.”
It all sounds familiar, doesn't it?
The “wave speech” at the end of Thompson's eighth chapter is considered by many to have most completely captured the hippie zeitgeist of the 1960s. It is a metaphor for our economic state as well.
There was madness in any direction, at any hour. If not across the Bay, then up the Golden Gate or down 101 to Los Altos or La Honda.…You could strike sparks anywhere. There was a fantastic universal sense that whatever we were doing was right, that we were winning.…And that, I think, was the handle—that sense of inevitable victory over the forces of Old and Evil. Not in any mean or military sense; we didn't need that. Our energy would simply prevail. There was no point in fighting—on our side or theirs. We had all the momentum; we were riding the crest of a high and beautiful wave.…So now, less than five years later, you can go up on a steep hill in Las Vegas and look West, and with the right kind of eyes you can almost see the high-water mark—that place where the wave finally broke and rolled back.
—Hunter S. Thompson, Fear and Loathing in Las Vegas, “The Wave Speech”
Just as Fear and Loathing in Las Vegas became a benchmark in American literature about U.S. society in the 1960s and the early 1970s, the melodrama of the past five years is becoming a seminal economic and investment experience.
Parallels can easily be drawn between the drug addictions in Hunter S. Thompson's book and the credit addictions in the new millennium, and the withdrawal from the most recent dependency on debt has had unrivaled implications. The unwind will continue to be painful for some time to come.
“Sometimes I lie awake at night, and I ask, ‘Where have I gone wrong?’ Then a voice says to me, ‘This is going to take more than one night.’”
—Charles M. Schulz
It took a while for our country to turn around from the 1960s. There are still those who have not left the decade of peace and love. Similarly, it will likely take time for our country to turn around from the abuse of credit and the consumption binge experienced in the 2000–2006 interim interval.
A moment last Monday, just after noon, in Manhattan.…I'm in the 90s on Fifth heading south, enjoying the broad avenue, the trees, the wide cobblestone walkway that rings Central Park. Suddenly I realize: Something's odd here. Something's strange. It's quiet. I can hear each car go by. The traffic's not an indistinct roar. The sidewalks aren't full, as they normally are. It's like a holiday, but it's not, it's the middle of a business day in February. I thought back to two weeks before when a friend and I zoomed down Park Avenue at evening rush hour in what should have been bumper-to-bumper traffic.
This is New York five months into hard times.
One senses it, for the first time: a shift in energy. Something new has taken hold, a new air of peace, perhaps, or tentativeness. The old hustle and bustle, the wild and daily assertion of dynamism, is calmed.…
Any great nation would worry at closed-up shops and a professional governing class that doesn't have a clue what to do. But a great nation that fears, deep down, that it may be becoming more Suley than Sully—that nation will enter a true depression.
—Peggy Noonan, Wall Street Journal op-ed, “Is ‘Octomom’ America's Future?”
Nowadays, investors lead lives of noisy desperation.
The fear and loathing is palpable:
Fear and loathing also abounds from the transparency and partisanship of our all-too-visible political process, which has served to further reinforce a negative feedback loop.
The headwinds working against an economic resolution this year seem cast in stone. Those few who still express confidence in a second-half recovery, similar to the characters Raoul Duke and Dr. Gonzo in Fear and Loathing in Las Vegas, are either taking too many drugs or are oblivious to the clogged transmission of credit, the steady drop in business and investor confidence and the general waning of business activity.
And I don't know about you, but I've got a sick feeling in the pit of my stomach—a feeling that America just isn't rising to the greatest economic challenge in 70 years. The best may not lack all conviction, but they seem alarmingly willing to settle for half-measures. And the worst are, as ever, full of passionate intensity, oblivious to the grotesque failure of their doctrine in practice.
—Paul Krugman, New York Times op-ed, “Failure to Rise”
There are significant positive developments amid the tumult that are currently being ignored.
Investor return and economic expectations have been ratcheted down as business activity is reset lower. As illustrated above, even Peggy Noonan's normally optimistic prose in WSJ has disappeared; she is sounding almost Krugman-esque in the face of the current economic malaise. Today, there is almost unanimity that neither an aggressive monetary policy nor a massive stimulus program nor an unprecedented and large bank rescue plan will have any possibility of success. Another positive. And, with the exception of the few remaining perma-bulls, most now appreciate that the consumer is cooked and that the great unwind of credit will be a headwind measuring in years not months.
Some more optimistic signs can be seen in sentiment such as the growing popularity of Cassandras as well as the better price action of certain segments of the market. (Markets always lead fundamentals.) The emergence of this sort of performance is a positive market tell and is a growing contrast to the uniform and correlated drop in almost every asset class during the second half of 2008.
In and of itself, an extremely negative sentiment cannot be expected to be an overriding tailwind in a backdrop of uncertainty. Despite the poor market landscape, however, there are some early signs of stability/revival, even before the stimulus is put in place. They are, admittedly, tentative signs but positive signs nonetheless.
Here is a partial checklist of signs that I and others are looking for (and their status in italics) as indications for a more favorable stock market:
While sentiment and valuation are not the sine qua non in determining share prices, it should be underscored that the current bear market is the second-worst in history, both in terms of price decline and the erosion in price-to-earnings (P/E) multiples. This means that embedded expectations are low. While sentiment, as measured by hedge fund and mutual fund redemptions, remains acutely negative, individual, sovereign and institutional liquidity remains abundant and is growing swiftly.
On multiple fronts, equities appear to have incorporated the bad news and are undervalued both absolutely and relative to fixed income:
“The most common cause of low prices is pessimism. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer. None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling.”
—Warren Buffett
Today's growing investor disaffection and apathy with regard to equities has, at its root, Hunter S. Thompson's fear and loathing. Both have given voice to the mind-set of a generation that had held high ideals and, as it relates to stocks in 2009, is now crashing hard against the walls of American reality in credit and finance.
If it all sounds familiar, it is, as both the 1960s and the 2000s were the decades of dopes.
After the speculative boom of the 1960s, the U.S. stock market fell into the early 1970s, but the extension of the popularity of the “Nifty Fifty” kept the market in gear for a few more years. After the Nifty Fifty bust in 1973–1974, the markets resumed a modest ascent in 1975, which petered out two years later. By 1982, 12 years after the close of the 1960s, the great bull market of the modern era began, despite loud chants that “the sky was falling” by the increasingly populated community of Cassandras.
“My pessimism goes to the point of suspecting the sincerity of the pessimists.”
—Edmond Rostand
Most investors entered 2008 with a far too constructive market and economic view. I did not, and it seems as though this greybeard's historical perspective was precise, as most of my concerns were realized. To be honest, most of my concerns have been eclipsed in recent months.
As we move into the midway point of the second month of 2009, market participants generally now have the opposite point of view of 14 months ago. I respect the fear and loathing, but I do not share the prevailing pessimistic view that John Mauldin substantiates in his brilliant and peripatetic “Thoughts from the Frontline” this week, as he argues that world trade is falling off the cliff, the magnitude of the world's bank write-offs are daunting and unknown, leading economic indicators are deteriorating, job losses are intensifying, S&P earnings are being adjusted downward to unfathomable levels, Secretary Geithner's bank rescue package is vague and that the stimulus program might only be a Band-Aid over a broadening set of problems.
It's downright, well, maudlin.
Today, the doomsayers are far more visible compared to after the dissolution of the Nifty Fifty advance in the 1970s, but my sense is that we don't have to wait anywhere near seven years (2016) for a resumption of a new bull market, as policy is going to be aggressive and immediate.
Arguably, John Mauldin's (and others') issues are now being incorporated into market expectations.
My economic view remains materially unchanged. We are likely in the Great Decession, somewhere in between a garden-variety recession and the Great Depression of the 1930s. We will, in the months ahead, continue to find out the many whom have been swimming naked as the tide goes out. And to continue with the Oracle of Omaha's references, it might be too early to be greedy when others are fearful, but I suspect that we are not far off from there.
The average recession in modern financial history has lasted 10 and a half months. The longest recession was between 1929 and 1933—real GDP dropped by over 25%!—and lasted 43 months; the shortest (1980) lasted only 6 months. I expect the Great Decession, which began in November/December 2007, to end in early 2010, or about 12 months from now. If accurate, the current recession will be the second worst on record, having lasted about 27 months.
It's so bad out there that some are questioning whether the world's economies will ever recover from the current mess. In doing so, they seem to be ignoring not only an emerging valuation opportunity but a number of events that should conspire to bring us out of the abyss, including (but not solely) the magnitude of the monetary and fiscal stimulation, the consumer tax cut and corporations' margin benefit from lower commodities (particularly of an energy kind), improving investor liquidity, the lowered cost of credit and a sentiment extreme of negativity.
At the risk of going Gonzo or garnering allegations that I could now be suffering from a hallucinogenic flashback from the 1960s, starting to average into the U.S. stock market could begin to make sense sooner than later.
When I objectively weigh all the body of evidence (the positives and the negatives above), I conclude that we are likely at the lower end of a broad trading range for the S&P 500. Fourth-quarter 2008 lows should hold.
We almost certainly remain in an exquisite trading market but an unimpressive investing (buy-and-hold) market for numerous reasons, including the great unwind of debt, the hit to household wealth and psychology after the deep drops in home and equity prices, the unique nature of this cycle's synchronized world economic falloff and the uncertainty of policy. Thus, a sustained market advance remains a low probability.
While much economic and corporate ugliness can and will likely occur in the year ahead, if year-end 2009 does mark the beginning of the end of the Great Decession, as I have surmised, stocks over the next few months will likely begin to discount stabilization well in advance, especially given the reasonable levels of valuation addressed previously.
To conclude, the lowering of the bar could be closer than many think, but the path to reach it remains icy, so investors should still tread carefully.
Despite the fear and loathing on the part of investors, I am beginning to find value and, for the first time in several years, I am in a (slightly) net long position.
Gun to my head, my baseline expectation is that the S&P could end up with a mid- to high-single-digit return for the full year, or about 15% above current levels.
Many stocks will rise more dramatically.
Color me a bit more bullish.
For the first time ever, I spent nearly a full hour with my favorite host, Sir Larry Kudlow, on CNBC's The Kudlow Report last night.
From my perch, the feature of the show was my call that the U.S. stock market could make a 2009 low this week, a very tough call but a position that I have been edging toward over the past several days.
The lion's share of the last segment of The Kudlow Report was devoted to my analysis of Warren Buffett and Berkshire Hathaway, and my market bottom call is made near the end of the segment.
My contention, as discussed on last night's show, is that the serious problems have been more than fully discounted in the world's equity markets. Moreover, while many have grown increasingly impatient with the new administration's piecemeal strategy toward addressing the banking industry's toxic assets, a cohesive deal, under the leadership of Lawrence Summers, will soon be forthcoming and will be effective.
The investment pyramid consists of the three angles of fundamentals, sentiment and valuation. I made this market bottom call based on my expectation of an early-2010 stabilization in the economy (making the 27-month recession the second-longest in history) coupled with an extreme sentiment and valuation swing. (As Dennis Gartman is fond of saying, sentiment and valuation have moved from the top left of the chart to the bottom right of the chart in an historic fashion.)
I am fully cognizant of the magnitude of our economic and credit challenges and that the future is not what it used to be. Indeed, my expectation of the Great Decession remains intact and is my baseline expectation.
The difficult fundamental backdrop and rapidly descending stock prices have resulted in a particularly volatile period.
I am also fully aware that most forecasts (of a stock and economic kind), especially at inflection points, are inaccurate or difficult to time, and I know that I am catching a falling knife, which is often an expensive and painful proposition.
Two to three years ago, I had a variant view, and I made a bearish call on equities at a time when (prima facie) all appeared healthy. While I clearly saw the developing cracks in the foundations of credit, in the economy and in the world's stock markets, the media, investment strategists, and mutual fund and hedge fund managers wore rose-colored glasses as they were almost universally bullish. Today, most of the same group, many of whom have been destroyed by the bear market, can see no light at the end of the tunnel, and frankly, this bolsters my confidence in the call.
It is now time for me to adopt another variant view by espousing a more bullish opinion on the U.S. stock market.
“Most of the time, common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble…to give way to hope, fear, and greed.”
—Benjamin Graham
I remain firmly committed to the notion that we are in the land of Chicken Littles and that the world equity markets are now tracing an important bottom.
For the second consecutive week on CNBC, I reiterated my more optimistic message.
Last night on CNBC's Fast Money, Dylan Ratigan started my segment with a quote from The Intelligent Investor's Benjamin Graham that underscored a still-expensive market. Essentially, Yale's Dr. Robert Shiller made the case that applying Graham's view that a 10-year period of smoothed corporate profits took out distortions and concluded that the S&P 500 index trades at 13× compared to a multiple under 10× at the bottom of the last three recessions, suggesting that U.S. stocks were about 25% overvalued.
My response was that the investment mosaic has grown a lot more complicated and a 10-year period provides far too few empirical data points, and it is too linear to use only one model, as Shiller suggests.
I prefer to look at multiple models. As it relates to Graham's observation, I would prefer to look at normalized earnings (12% return on earnings) on the S&P's book value of $560—or earnings per share of about $67 a share. Over a lengthier and more statistically significant period—seven decades—stocks tended to trade at 15× normalized S&P profits (S&P equivalent of 1005) and bottomed at between 11.5× and 12.0× (S&P equivalent of 787). We are now at only 685 of the S&P, or at a 10× multiple, so rather than being overvalued—as Benjamin Graham/Robert Shiller might opine—stocks have overshot the downside valuation that has historically provided support and now appear undervalued.
In the Fast Money segment, I detailed multiple valuation models I use to assess the current value of U.S. stocks, all of which make clear that equities have incorporated a lot of bad news and are undervalued both absolutely and relative to fixed income.
It is also important to recognize the importance of the value of stocks relative to fixed income and inflation, as Zachary Karabell mentioned last night. I do:
Not only are there few who believe that we are making a bottom but there is virtually no one who thinks a sustainable market rally is possible.
Chicken Little has regained credibility.
Nearly everyone can explain why the market has gone down and why it is unlikely to rebound, but hardly anyone can find a reason to rally. The business and general media, in marked contrast to the past, almost refuse to consider factors that can contribute to a sustained advance in stock prices.
It is important to recognize that only a handful anticipated the current credit and economic travail, nevertheless, the alacrity and confidence of a dire outcome in the land of the Chicken Littles is something for me to behold.
Three years ago, cash was not king, the buying power of private equity dominated the investment landscape, and no takeover (regardless of size) was impossible. Endowments, pension plans, banks and hedge funds jumped headlong into the leveraged world of private equity.
Even two years ago, mutual and hedge funds were enthusiastically invested in equities (especially of a materials, commodities and energy kind) as the newest paradigm of economic decoupling gained credence.
Today, cash (and liquidity) is back on the throne as king, as the great unwind of debt and the liquidation of overlevered investments gains momentum as the hedge fund industry implodes further.
Take the advice of the Johnny-come-lately Chicken Littles if you will, but trust me, they will not anticipate recovery, nor will they (like the cagey fox) participate in feasting on the developing and unprecedented values.
Attractive valuations, a negative sentiment extreme and early signs (and expectations) of economic stabilization are moving closer to reality.
The sky is not falling, as value is on our doorstep and dinner is being served.
Last night I not only reemphasized my 2009 market bottom call on The Kudlow Report, I also suggested the possibility that a generational low is being put in place.
Yes, I said that.
The most vociferous bull on our segment, a nice fellow from Boston who has been bullish most of the way down, got weak in the knees because of the magnitude of yesterday's market ramp. He actually said investors are getting too optimistic in only one day.
My response was that considering that the hedge fund industry is at its lowest net long position in years and since individual investors have recently accelerated their account liquidations and redeemed their mutual funds, they are not even thinking about getting back in. There is plenty of buying power sitting on the sidelines to fuel a sustained market advance.
But both institutional and individual investors will get involved again—if the market can post several days/weeks of strength. And there remains a huge asset allocation trade back into equities from cash-rich pension plans whose portfolios are now materially skewed toward fixed income.
Most will miss the rally—it's not surprising since the pain has been so extreme in recent months.
The purists will point out to a bunch of indicators that have yet to fall into place such as a low put/call ratio. But my response is that most buy puts to protect longs, so with most investors being light on equities, there is less of a need to buy protection in puts. So it is not surprising if the put/call ratio stays historically low, as long positions are historically low and cash positions are historically high.
My best guess is that we'll rapidly move back up toward the typical bear-market trough valuation—12× normalized or trend-line S&P earnings of about $67 a share, or about 805 on the S&P 500. In the fullness of time I expect the S&P to test its 200-day moving average, which is currently about 30% above yesterday's close.
Yes, I said that, too!
Nearly two weeks ago, I suggested that a 2009 market bottom had been put in, and last week, I surmised that, in the fullness of time, a generational market low might have been put in for the U.S. stock market.
At inflection points, gauging the market's technical bearings is often useful as is a history lesson, so let's travel that route.
A deep oversold, worsening sentiment and positive internal divergences almost always provide the foundation to stock market recovery.
The move from the October lows to the March lows indicated growing fear and gave way to rising cash positions and the loss of hope, but the market's internals were improving. November's Dow Jones Industrial Average low of 7,552 was nearly 11% below the October low of 8,451, and the March low of 6,547 was 22.5% under October's low.
While each new low was more frightening than the prior one, there were improving technical and sentiment signals. For example:
As well, new lows traced decreasing levels:
From a sentiment standpoint, the March low marked an unprecedented number of bears, according to the AAII survey.
Last week (and right on cue!), we witnessed conspicuous breakouts and strengthening momentum off of Monday's bottom. The combination of Tuesday's 12:1 ratio of advancing stocks over declining stocks coupled with that day's 27:1 up-to-down volume ratio has not occurred in almost 65 years. The 9% three-day rally and rising volume on two 90% up days were very encouraging. I was also inspired by the strength of financial stocks and the ability of many stocks (e.g., General Electric) to advance in the face of bad news. (In the case of GE, there was a Fitch downgrade late in the week.)
Most strong rallies don't let investors back in easily and get overbought quickly. I expect the current one to be sharp initially and to continue without much of a retest over the next week, creating a short-term overbought by month's end.
So, how now, Dow Jones?
“History doesn't repeat itself; at best, it sometimes rhymes.”
—Mark Twain
As a template, I expect the 2008–2009 stock market price pattern to most resemble the 1937–1939 period, which holds a number of similarities to the current period:
The 50% drop over a five-month period in 1937–1938 holds a similarity to the market's recent drop in that neither had a high-volume selling climax. The market's 1938–1939 recovery, perhaps like 2009's, had four legs and lasted about seven months.
Leg one of the 1938–1939 rally was brief and intense; it lasted only about 12 trading days, and the indices rose by 19%. Leg two was an approximate 60-day consolidation that corrected half of the initial gain. Leg three was about a six-week rise of 30%. Leg four consisted of another two-month consolidation and retracement followed by a 22% six-week rally, serving to mark a multiyear high in the averages.
I expect a similar pattern (as in the late 1930s) to be traced ahead in 2009.
In the months ahead, the fear of being in will be replaced by the fear of being out.
A poorly positioned hedge fund community, with historically low net long exposure and rankled by negative investment returns and the fear of continued redemptions, should provide the initial thrust to the S&P's 50-day moving average of about 810. Again, it is important to recognize that, historically, strong rallies that have durability (similar to 1937–1938) typically don't let investors in during the first advancing leg. With such a clear burst of momentum, the fear of being out could drive the S&P 500 as much as 15 to 40 points above the 50-day moving average, paralleling the 20% third-quarter 1938 move and producing a short-term top and a temporarily overbought market.
The spring should be characterized by backing and filling as the sharp gains are digested, similar to the September–October 1938 interval. Second-quarter warnings will weigh on the market during the April–May period, but the markets could move sideways, bending but not breaking. Signs of market skepticism, sequential economic growth and evidence of a bottoming in the residential real estate and automobile markets (after a sustained period of underproduction) could contain the market's downside, providing a range-bound market with a firm bid on dips. As well, the results from the bank stress tests and the release of a more coherent and detailed bank rescue package could provide further support to equities.
By June, economic traction should begin to take hold from the accumulated fiscal and monetary stimulation coupled with the large drop in energy prices. While it will be too early to demonstrate a broad economic recovery, evidence of stabilization will be clearly manifested in improving retail sales, and stocks will take off for their final advancing phase. With fixed income under increasing pressure, large asset-allocation programs at some of the largest and late-to-the-party pension plans (out of bonds and into stocks) could trigger an explosive rally in the middle to late summer. This move by July or August could close the October 2008 gap in the SPDR S&P 500 exchange-traded fund (SPY) at around $107.
Early in the week of March 2, I appeared on CNBC's The Kudlow Report, where I asserted that the U.S. stock market was within three days of bottoming for the year, and quite possibly for a generation. On Friday, March 6, following two days of further market weakness, I reaffirmed my prediction that the bottom was in.
A week later, on March 9, I reemphasized my generational low bottom call to a skeptical crew on CNBC's Fast Money. On that show, I cited multiple valuation models I use to assess the current value of U.S. stocks, all of which made it clear to me that equities have incorporated a lot of bad news and were undervalued both absolutely and relative to fixed income.
At the time, there were few who believed that stocks were bottoming and literally no one who thought that a sustainable market rally was even remotely possible.
The extreme negative sentiment that was associated with those conditions sowed the seeds for the bountiful harvest over the past four weeks.
With the benefit of hindsight, value was being put on our doorstep, and dinner was being served four weeks ago.
The first week of March marked the market bottom, and the performance of stocks over the past month has been the singular best four-week performance since 1933.
Many have now boarded the love train.
Once again in March, as has happened in prior cycles' inflection points, markets have discounted the worsening rearview mirror and have peered optimistically into the future. Importantly, it is abundantly clear that we now have enough domestic economic data to point to a bottoming of production declines. This is particularly true as it relates to an imminent recovery/stabilization in housing, which is being catalyzed by a Fed-induced reduction in mortgage rates, record gains in affordability, and a more favorable economic proposition of home ownership vs. renting.
Housing markets will bring us out just as they brought us in.
My month-old S&P forecast is materially on forecast. As a reminder, it was predicted on a parallel with the conditions that existed in the 1937–1939 U.S. stock market.
If the pattern of my prediction unfolds, the market will have only another 2% to 4% upside before a two-month price consolidation takes hold.
If the above consolidation expectation is on target, gaming the markets will likely hold the key to delivering superior investment returns, especially over the next two to three months.
Short term, the market outlook will be importantly influenced by investor psychology and the degree to which public policy translates into economic traction.
In marked contrast to early March, when we were in a bull market for pessimism, today many have recently come aboard the stock market's love train and have turned more constructive:
Importantly, my early March variant view is no longer so.
The consequences of worshiping at the altar of price momentum can be punitive to the recently converted. One has to look no further than the recent downturn in gold shares and in the metal commodities, both of which became overowned and overbought asset classes.
Several other fundamental and technical factors could conspire to contribute to a period of market uncertainty and a healthy several months of backing and filling.
Weighing against the near-term consolidation argument is the historically significant improvement in the market's internals and breadth of the rally, with six 90% up days in four weeks, reflecting an abrupt change from the fear of being in to the fear of being out and left behind.
Regardless of whether a near-term consolidation is in the offing, volatility will remain heightened, and my formerly implausible S&P forecast now seems plausible.
Similar to The Little Engine that Could, the U.S. stock market appears positioned for further progress, and my mid- to late-summer destination of S&P 1,050 remains on target.
I think it can…I think it can.