The Case for a Stocks Bear Market Rally

By: Hans_Wagner

Are we in a bull or bear market? That is the question many are asking with the S&P 500 up 50% from its March 9th low. Whether we are in a new bull market or just experiencing another bear market rally is important for investors to answer. Today, I will present the case for a bear market rally. In the next few days, I will offer why the bear market is over.

In early 2009, the economy looked over the precipice and saw a deep depression looming. The market entered a bear market that plunged to significant lows. Since then the market has rebounded rising 50% from its low of 666 on the S&P 500 in early March Is this move up by the market a new bull market or a bear market rally?

Whether we are in a new bull market or experiencing a bear market rally depends on your view of some important economic factors including the state of consumer spending, the role of the financial sector in the market, the valuation of the S&P 500 and investors’ appetite for risk.

Consumer Unable to Spend as Before

So far, the consumer has not returned to their free spending ways even after the government stimulus. After having seen their savings disappear, many people are putting their extra money into savings. While the higher savings rate does not help the GDP expand in the short term, it does provide a stronger capital base, a positive for the long-term health of the economy. A new bull market needs to see consumer spending return to help push up the GDP of the U.S. Without consumer spending, we are more likely to be experiencing a bear market rally.

Since the credit market was the major contributor to the collapse of the housing market, we need to start our review there. A study by Atif Mian and Amir Sufi of the University of Chicago’s Booth School of Business found that house prices and household debt increased most where the supply of new housing was limited. In places where there was limited space to build, prices rose more, bring with it, more borrowing. On the other hand, in cities where homes can easily be built to meet demand as there is plenty of space, the prices did not rise, and debt barely rose.

To understand the connection of home price values and debt, the researchers limited their sample to those who were homeowners in 1997, before the boom in housing and credit. This allowed them to measure how much of the rise in debt was the result of cashing in on higher home values. They concluded that almost 60% of the increased debt between 2002 and 2006 came from homeowners cashing in on their higher home values. The authors estimate that almost all of the $1.45 trillion that was borrowed against rising home equity was used for spending.

An even more worrisome finding from the study was borrowers in the lowest quartile of creditworthiness borrowed more readily. Between 2006 and 2008, more than a third of the loan defaults were due to home-equity based borrowing. This suggests the consumer will not be able to return to their former levels of spending, as they cannot depend on rising home equity values to fund their spending. Without growing contribution from the consumer to the economy, GDP will not grow as expected. This causes us to face a bear market rally rather than a new bull market.

The Financial Sector’s Rebound is from an Artificial Low

The financial sector is an important component of the stock market. In the market meltdown early 2009, the financials plunged as investors feared many banks would fail much like Lehman Brothers. Once some confidence returned in March, the financials led the rebound in the market. This has caused some investors to believe a new bull market is underway.

However, the rebound by the financials is not sustainable as new credit problems still exist. Foreclosures are still rising and the commercial real estate market is rapidly becoming a major problem. The market overreacted to the financial sector to the down side and now it is doing the same on the upside. The rebound by the financials overstates the strength of the recover by the market. Any weakness in the financial sector will negatively affect the market. This is a classic indication of a bear market rally, not a new bull market.

S&P 500 is Overvalued

S&P 500 is trading at 27.5 times the consensus estimate of 2010 earnings. The historical average is about 15. With 99% of all companies reporting, Standard & Poor’s is reporting that based on “as reported earnings” the trailing PE ratio for the S&P 500 is over 130 based on a closing price of 1,025. A PE ratio this high does not give any room for the market to rise.

Moreover, companies have improved their bottom line performance by cutting costs not increasing revenues. Any time the PE ratio is so high we should expect more downward pressure on the market.

As a result, we are looking at another indication the recent rise in the market is just a bear market rally and not a new bull market.

Savvy Investors Reducing Risk

Investors who manage large funds understand that loss of capital is of utmost concern. As astute investors, they seek ways to lower their risk, especially after experiencing a nice run up in the value of the portfolios they manage.

Recently, the demand for low risk Treasures is climbing as yields are falling, indicating there are more than enough buyers for these bonds. Besides China, investors are buying Treasuries to lower their risk profile of their portfolios. If these investors expected the rally to continue, you would see them reducing their holdings of Treasuries as they sought to generate returns to match the market.

Speaking of large investors, according to Trim Tabs Research, in July hedge funds lost $26.2 billion in fund out flows. If this were a new bull market, they would be adding money into these funds.

In addition, companies are no longer buying back their own stock. Instead, they are selling more than 6 times as many shares as they are buying. Trim Tabs reports that stock sales by insiders rose to $6.1 billion in August, while insiders only bought $160 million of their own company’s stock, a 38:1 ratio. According to Thompson Financial, readings below 12:1 are bullish and over 20:1 are bearish. Though to be fair, Thompson Financial is reporting that the insiders’ transactions ratio is slightly above 12:1. One measures value of shares, while the measures number of shares sold or purchased.

When managers of large funds reduce their holding of stock on the belief the rally might be ending, it is another indication that we are in a bear market rally and not a new bull market.

The Bottom Line

These factors indicate the market rally is more likely to end soon, rather than continue. The question whether we are in a new bull market or a bear market rally favors the latter. Bull markets need to see growing evidence that the economy has underlying strength and that the financial sector can continue to be a leader. The high valuation, as the PE ratio shows, gives little room for further expansion other than through growth in earnings. Moreover, the high valuation increases the risk of a pull back in the markets. Finally, perceptive investors are reducing their risk profile of their portfolios taking money out of the market.

As indicated, we are experiencing a bear market rally that will end soon. While the market can climb a wall of worries, these fundamental factors tell us a new bull market is not in the cards, rather we will soon see a bear market rally.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2009 Hans Wagner

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