We need a pullback, BUT...

In my opinion, the market needs a pullback, BUT this is a buy the dip market.

I don't think we're going to see a 20%+ decline, however much this would cleanse bullish ardors. If we're lucky, we'll get a 10%-15% correction, then it is off the races again (maybe not quite the races, but a 1200 target on the S&P 500).

The time to sell this market will be when the authorities try to pass the baton from the public sector to the private sector. That is not likely to happen before the middle of 2010 for monetary authorities and may never happen on the fiscal side of the ledger (just a little tongue in cheek). The critical point will be to anticipate when the market is going to get antsy about the transition (it may be six months beforehand, it may be longer or shorter).

Note: Geopolitical uncertainty brought about by an attack on Iran by Israel, a large terrorist attack on US soil, or heightened trade tensions could throw a spanner in the works.

The Problem With 'New Normal'

The problem with the 'new normal' meme is that history is against it. Essentially, the argument for a 'new normal' is an argument for 'this time it is different.' And as we all know, 'this time is different,' is a dangerous position to take. Now, I happen to have a lot of sympathies for the argument and think it pretty reasonable (mainly because we're still overlevered and heading into delevering headwinds [higher taxes, lower consumption, structural deficits, structural unemployment, rising rates, etc.]). But, the problem with the new normal (and all the well considered bear cases of the past [and future]) is that they typically discount the resilience and dynamism of the economy. And it is only with the benefit of hindsight, that we see how it was we escaped the myriad of obstacles encountered and imagined. I don't know how we're going to escape the scythe this time around (as I said, I have my doubts), but the trendline of history reveals bumps, large and small, that are overcome in the course of time. Perhaps, this time is different (and we go through a period similar to the 'heisei malaise' or even something resembling the double-dip of The Depression), but it takes a brave person right now to discount all the market factors flashing green:
- Upturn in M&A (indicates pro-cyclical bias and confidence of boards and management),
- Rejuvenation in the IPO market,
- Significant recovery in credit markets,
- A benign bond market and low interest rates,
- Large fiscal stimulus still to come,
- A strong and resilient stock market,
- Increasing confidence among consumers,
- Economy showing rebound,
- Housing moving off the bottom,
- Resolution of healthcare reform,

A Game of Chicken

Since the mid-80s, playing the stock market has essentially been a game of chicken. The market's normal condition is one of overboughtness and overvaluation. Naturally there are times when it is more overbought and more overvalued than at other times, but the game has been to stay long and stay the course (and hope you can get to the exit before the music stops). This was logically underpinned by technological revolution, a generally robust economic environment, and the ideas of free market liberalism. Unfortunately, the period was also marked by a significant increase in leverage among governments, corporations and consumers. All good things must come to end, and it would appear that the financial crisis, sweeping electoral victory of Barack Obama, and coincidental recession of 2008-09 mark the end of that era. It remains to be seen what the future holds, but the early money is upon higher savings, lower consumption, higher taxes, increased govt spending, and greater regulatory constraint. Not a particularly exciting mix. But companies will still grow and make money, and investors will still be able to derive a decent return on investment (a 60% mark-down in asset prices does wonders for long term expected returns). However, the transitional pains of recalibrating from one state to another imply greater dislocation within and among economies, with a concomitant increase in volatility effecting asset prices and asset markets. Welcome to the new game of chicken.

Chicken vs the egg

Q. Are banks not lending, or borrowers not borrowing?
Ans. Both.

The money base has expanded rapidly, but falling monetary velocity has offset that expansion. During this period, banks have tightened lending standards (falling consumer lending), and credit worthy borrowers have been reluctant to take on more debt (more interested in paying debt down and repairing their market ravaged balance sheets).

The result has been buoyant asset markets as banks have redeployed their excess reserves to proprietary trading activities.

This can't continue ad infinitum. At some point, credit markets and the economy will normalize.

The Trigger

The problem bears face at the moment is one of timing. Economic tailwinds and improving sentiment look unsurmountable, at least until the Fed starts tightening. And given that most bears either don't expect the Fed to tighten, or don't see it happening until mid-2010 or later, it could be painful watching this juggenaunt from the sidelines.

That having been said, we have been on easy street for so long now that any vestiges of caution are castigated as something "quaint." As such, it is hard to know what might trigger a reversal in sentiment and equity fortunes. If we continue to rally into quarter end, then earnings could end up being a classic "buy the rumor sell the fact." But even with improving expectations about earnings, a positive outlook and strong momentum could blunt any retracement as folks "buy the dips."

Beyond upcoming earnings however, there are any number of amorphous economic, political and geopolitical factors that could arrest the rise. Unfortunately, in the absence of 20/20 foresight, the best you can do is monitor the conditions and look for any signs of a break in the weather.

Small-Mid Caps lead the way in US

The S&P 1000 peaked at 5275 on 7/17/07. It fell to a low of 2225 on 3/6/09. As of today it is currently around 3879.

Peak to trough fall of 58%. Rally from low of 74%. Index currently 26% below peak.


The S&P 500 peaked at 1576 on 10/11/07. It fell to a low of 667 on 3/6/09. As of today it is currently around 1054.

Peak to trough fall of 58%. Rally from low of 58%. Index currently 33% below peak.

The S&P 1000 hit an airpocket around 4300 in late September 08 (falling quickly to a low of 3000 by October 10). My sense it that it will test the 4000-4200 range, but fail.

One step forward, two steps back

It seems to me that we have entered the final phase of this rally. One which could take us one step forward and two steps back.*

As it stands, it is hard to see much standing in the way of the market continuing its rally right now. Economic data is supportive, trend data is supportive, sentiment indicators are supportive, flow data is supportive, breadth is supportive, monetary policy is supportive. For those who haven't participated in the rally to date, I can't help but think that they are playing a dangerous game.

*The one step forward could be another 10%-15% move on the upside (ie. take us to 1140-1200), while the two steps back could be a 15%-20% correction on the downside (ie. 900-950).