Awakenings from a false dawn

At the start of the year, investors, fresh from the festivities, continued where they left off in the so-called year-end rally, and started bidding stocks higher. That helped the stock market rebound more than 25% from its November 21 2008 low. With more money in debt and money markets than equity markets for the first time since World War II, a rally could be spectacularly explosive. Looking at all the positive market indicators--rising oil prices, higher volume, rising indexes--there was a real sense of anxiety that the worst may be over. It may not sound right, that you actually wish for the worst to befall others. But it's just greed. It's just business.

The thing is, if we are on the road to recovery, in the sense that the worst quarter for the world economy was the 4Q 2008, which isn't saying much actually because it was extremely bad (or so we are led to believe), then we should see a bottoming out of stock prices anytime now, because conventional wisdom has the stock market as a 6 month leading indicator of economic health.

Indicators are misleading. They pretend to tell you a lot, but actually they don't. (Which is good actually, because you don't want the stock market to flash green lights for all to see so everyone can see its time to buy. Then you'll always be too late.) Oil prices have since rebounded from the rock bottom of $35, briefly touching $50 due to the Gaza wars, and the Baltic indexes have corrected by quite a bit too.

But any talks of a sustained rally is, at best, premature. The anticipated rally from the Obama presidential inauguration on Jan 20 2009 is not materialising. Instead investors are bracing themselves for what could be a worse-than-expected 4Q corporate earnings. In the space of 1 trading session (Jan 12 2009), financials are surrendering their gains since their November 21 low, and are threatening to breach that low all over again. Like a patient in ICU, a "stable but critical condition" has now suddenly--as usual--"taken a turn for the worse."

The depressed market trading conditions is suggesting that the year-end rally is beginning to take shape as just another bear rally in the grand scheme of a severe downturn. The dead cat has bounced? As an aside, the phrase comes from traders, whose morbid imaginations conjure up images of cats which had fallen from considerable heights and died under the circumstances, would nonetheless still bounce upon impact. That's what gloomy stock markets make you think about. You think about death.

Russell Napier, in trying to answer the million-dollar question, turned to history and examined 4 periods of extreme market undervaluations in 1921, 1932, 1949 and 1982, and found common themes, summarised here by FT's Tony Jackson, "Typically, the bottom was immediately preceded by a turn in commodities (copper especially), auto sales, corporate inventories and corporate bonds. Good news was, meanwhile, ignored by investors."

If we work through the list item by item, it seems that most of the conditions for a market bottom has been satisfied, especially with regards to commodity prices like copper which gained back some 20% since December, and oil, which rebounded from its low of $33.87 (Brent North Sea crude) in December 21 2008, to around $50 a barrel. US auto car sales may seem to be headed down, but once adjusted on an "annualised basis", they are actually not doing too bad. There is a palpable thaw in the credit market frozen over in the mayhem after the Lehman collapse. Bond yields have fallen and companies are issuing rights again.

But the conditions are scarcely enough. Dangling off the last of the list is an ominous remark about how "good news was ignored". It reflected the sentiments of those historic bears when markets were so bad that investors, apathetic to all sorts of news, have all but given up on the stock market.

It is clearly not the case now. Any reports of earnings that were less severe than expected would have the shares spiking straight up. Debenhams reported less severe than expected 4Q results and prompted a 20% rise in its stocks. When the BoE announced interest rate cuts to 1.5%, pushing the pound up(I am not sure why at this moment), the shares of British banks like Lloyds, Barclays and RBS rebounded very strongly in the space of a few sessions. Anticipating a massive auto bailout, investors bidded up the price of Ford from $1.50 to $3.50. Not good.

The thing is, if we are in the midst of a horrible bear market destined for an entry in the history books, and not just one of those barely mentionable cyclical downturns --technically the 2001 recession could be seen as one of "barely mentionables"-- then the bear market has further to go.

It sounds counter-intuitive, but analyst Jim Sibbet, paraphrasing Dow theorist Robert Rhea, explains that bear rallies and false dawns are mainly the effects of pockets of misplaced optimism investors still harbour about the economy, and when the true extent of the economic devastation is slowly revealed to us, piece by piece, the optimism will slowly be weeded out. That is when the market slides to its uncomfortable destiny with a truly unimaginable rock bottom, that is when the market has lost all hopes of recovery, that is when lights have been switched off at the end of tunnel, that is when everybody's mind is made up, and there is no way to go but up. And that is also that elusive bottom, the financial El-Dorado that everyone's been dreaming about. To go to heaven, you must first go through hell.

More ominously, there are some economists who think that we are actually having a continuation of a major bear market that began at the start of 2000. The underlying economic structures did not have a chance to fully recover before cheap credit papered over the cracks and ushered in a short-lived era of housing booms and false prosperity. If the fundamentals are severely damaged, it may take much longer for recovery to happen. I don't know why some like to quote from their CFA textbooks that a recession last for at most 1 year. The people who lived through the Great Depression never saw prosperity in their lifetime. Closer to our times, the Japanese endured a decade of zero economic growth. And we--the people of my generation--may become what others speak of in hushed tones, the lost generation.