Bear Market Rally?

Looking for a bear market? Turn to long-term government bonds...

JUDGING BY THE tidal wave of e-mails and comments I have received from numerous different sources, writes Dr.Marc Faber for Eric Fry's Rude Awakening, I am under the impression that most investors view the recent rally in the world's stock markets as a bear market rally.

I suppose we would need to define a bear market rally as a rally that fails to make a new all-time high (for the S&P500, above the 1576 reached in October 2007) and is also followed by a new low for this cycle (below 666, reached in early March 2009).

The problem I have with this dogmatic definition of a bear market rally is the following:

Assuming (and this isn't a forecast, since I really haven't the foggiest idea where stock markets will be in six or 12 months' time) the S&P moved up to 1350 and then declined to 500, as an investor should you care if the move to 1350 – a 100% gain! – was a bear market rally?

My impression is that investors' fixation on the recent rally being a bear market rally has actually kept most investors on the sidelines and hoarding cash. Now, put yourself in the shoes of a fund manager who, in the last 18 months, has lost 50% of his clients' money and missed the recent rally (34% for the S&P500). What is he likely to do? I would think that he would be inclined to purchase equities as they correct the sharp advance since early March, especially as the economic news in the near term becomes less negative.

Based on our conversations with numerous managers in recent weeks, we believe that most quantitative managers' portfolios were not positioned in expectation of a rally. Of the nearly 80 managers we have talked to, only one manager said they were up since March 9th, and the clear majority admitted to being notably down or stopped out on their positions. These managers were both long-only and long-short quant managers using market neutral and non-market neutral strategies, sector neutral and non-sector neutral strategies, longer term and intermediate-term holding periods. It is fair to say that just about everyone is bewildered and trying to understand when this rally will end.

Another factor to consider is that there has been a significant improvement in the technical position of world stock markets. In the US the largest number of new 12-month lows was reached in October. At the November 21st low at 741 for the S&P 500, the number of new lows had already contracted, and even more so at the index's March 6th low at 666.

Also, market breadth and the number of stocks moving above their 200-day moving averages have taken a decisive turn for the better, indicating that the stock market advance is broadening and that the number of stocks that have bottomed out (at least in the intermediate turn) is expanding.

But for the longer term, and for less active "trading" investors, I have explained repeatedly in the past that if a government is really determined to try and postpone an inevitable collapse by "printing money" in order to lift or support asset prices, it can be done. However, the result of such a monetary policy is to lower the purchasing power of its paper currency, with catastrophic long-term consequences for its economic and financial volatility.

It forces individuals and institutions with cash to buy something...anything. So, this cash is channeled into Gold Bullion or different paper currencies, commodities, equities, bonds, real estate, and consumer goods and services, but obviously with different intensities and at different times. For instance, at some times, such as in 2008, more money will be allocated to Gold Investment; while at other times, such as since early March, more money will flow into equities and industrial commodities. It is well understood that these money flows are driven largely by speculative activity (and more than a little dose of manipulation). The result in all asset markets is very high volatility and price fluctuations that don't appear to make any sense to most market participants and observers who don't understand the new rules of the investment game that were brought about by "money printing".

This is where we are today, irrespective of whether or not you and I like policies of "quantitative easing, massive bailouts, and frightening fiscal deficits" and their long-term consequences! Another positive factor for stock markets is that a large number of Asian stock markets and individual stocks in the region had already bottomed out in October and November of 2008 and didn't confirm the new low in the S&P in early March.

In Asia, the Taiwan and Shanghai indexes, and Korea's Kospi Index, are all up by more than 50% from their late October 2008 lows. (The Shenzhen Index is up 90%.) But it is not only the Asian equity markets that have outperformed the US and Western European markets over the last few months. Since late January 2009, the RTS Russian Index is up 66% and the MSCI Emerging Market ETF is up by 55% from its early November 2008 low.

This is not to say that the global economy is about to embark on a strong and sustainable growth phase. It also doesn't mean that a new bull market in global equities à la 1982 to 2000 has begun. But I think that, at least in nominal terms (inflation-adjusted), the global printing presses being run by the world's central banks and fiscal deficits have begun to impact asset prices positively. Therefore, in the case of resource and mining stocks, as well as Asian equities (and, for that matter, most emerging and other stock markets around the globe), the lows that were reached between October and March of this year are likely to hold – that is, for now.

The markets that have the highest probability of having made major longer-term lows are resource-related equities, emerging markets, and Japan. Conversely, the asset market that has the highest probability of having made a secular high (such as Japan in 1989, or the Nasdaq in March 2000) is the US long-term government bond market.

Despite a still-weakening economy and massive quantitative easing, long-term bond yields appear to be on the verge of breaking out on the upside.