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What to make of the market

Created:

1 May 2009

Written by:

Jonathan Eley

IS THIS BULL RUN FOR REAL? asked the front page of Barron's, the leading US investment journal, last Friday. The inside pages, based on a poll of US money managers, concluded that investors were generally bullish, but not yet ready to back up that conviction with extra capital. (Read the lot here)

Today's Financial Times, noting that the FTSE100 is now officially in a bull market, quotes influential former fund manager Anthony Bolton as saying that "all the things are in place for the bear market to have ended" (read article here). There is no shortage of strategists prepared to make similar claims.

But the investment world's Cassandras haven't rolled over just yet. In a strategy note yesterday, SG's Albert Edwards points out that US stocks simply have not plumbed the valuation depths they did in previous downturns.

"Despite one of the biggest economics and profit collapses in history, US stocks have failed to get cheap in the same way that they have in Europe or Japan. My concern is that the US equity bear market has not yet fully played out," he wrote.

Valuation relative to history is also a key reason for the scepticism of our own Simon Thompson. He notes that every US bear market for 90 years has bottomed out when the Shiller PE ratio (a valuation measure that smooths out year-to-year earnings volatility) on the S&P 500 has been below ten. Even when the S&P500 hit 666 in March, it was still on a Shiller PE of 11.5 (see When the bear market will end). The index is now at 872, a Shiller PE of over 14.

Others agree. "Secular bear markets usually end in extreme undervaluation, and this one started from the largest valuation overshoot ever," said Morgan Stanely strategists in a note earlier this week. They go on to point out that with capacity utilisation at such low levels, further pressure on earnings is inevitable. "For the industrials sector, 2009/10 forecasts are 40 per cent below their highs compared with 70 per cent in 2002/03."

Andrew Lapthorne, one of Albert Edwards' colleagues at SG, also picks up on this, noting that the second quarter historically has represented the ebb tide of earnings downgrades. The rate of downgrades usually picks up significantly later in the year.

But even if the bears have done enough to persuade you that this is not the start of a bull market, there's still the question of how long shares could go on rallying. At what point will it become clear the emperor has no clothes?

Not long, thinks Mr Edwards. "The current pop in the market is not dissimilar to the many bear market rallies between 1929-1933, where signs of economic stabilisation were met with 25% plus rallies... This optimism was subsequently crushed."

Is it "different this time", because of the unquantifiably vast fiscal and monetary stimulus the world economy has received? Bears have an answer to this one, too: "Japan". The land of the rising sun slashed interest rates and borrowed heavily to stimulate its economy in the 1990s, and there were several powerful rallies (over 50 per cent, in some cases) as a result. But the Nikkei 225 is still less than a quarter of its 1989 peak - and fresh doubts emerged today as to whether quantitative easing in the UK is actually having any effect (see Quantitative easing fails)