Will the Bear Rally Last?
Will the Bear Rally Last?
The five-week bear market rally has a head of steam up. From the 6 March low of 3122, the All Ordinaries Index is up almost 20%. It’s hard to see what all the optimism is about – unemployment is up, the Reserve Bank of Australia is concerned enough to cut rates to 49-year lows and the OECD is now predicting that the world economy will shrink by 2.7% in 2009.
Anecdotally, conditions in Australia are the worst most businesses have experienced.
I attend a business gathering once a month where 10 business owners and CEOs exchange ideas and discuss business issues. In November and December, more than half our group didn’t understand what all the pessimism was about. By February, eight of the 10 were describing conditions as the worst they had seen, ever (the other two are significant beneficiaries of the government’s $1.3bn school stimulus).
From a macro perspective, a substantial reduction in company profits has been a long time coming: margins and profits as a percentage of GDP were substantially in excess of their long-term averages (I was only four years too early, see Profits won’t defy gravity forever from May 2005). The recession is accelerating the adjustment process. But profits had to fall.
Of course, that might all be priced in. Fund manager Jeremy Grantham said the market doesn’t turn when there’s light at the end of the tunnel, it turns when ‘all looks black, but just a subtle shade less black than the day before.’
Perhaps we’ve already seen that day. It is futile trying to predict market movements. But investor optimism is certainly going be tested during the next few months.
From a company specific perspective, the rally has taken place in a month-long window that is historically light on information. Most companies – banks being the major exceptions – report their half-year results in February and full year results in August. March and April are typically quiet. But between now and the end of June – confession season – we’re going to see plenty of ‘market updates’.
Flight Centre and Qantas are out of the blocks early but by the time 30 June arrives, they will have plenty of company. We’re about to find out whether all the bad news was really priced in. Or not.
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Well I hope I don't sound too downbeat but I am disappointed. After many years of silly prices for good companies, they were just getting to be worth investing in, according to sound financial analysis, about the beginning of March, 2009. Then on the 16th of March, the US Congress insisted that the FASB change the mark-to-market rules to allow banks to revalue their bad debt as though it wasn't very bad at all, thereby reducing their needed write-offs and increasing their reported earnings and from that moment on the share markets in the US and Australia have gone up dramatically and haven't stopped yet - even though a number of highly reputable US bank analysts have stated that if the Notes of the financials are read the banks are still in very serious trouble. The disappointing thing about this is that the government's interferrence in the market is stopping intelligent investors from being able to understand the accounts of businesses and therefore rationally commit money to the market. At today's prices many companies are now again not worth investing in, but the average investor today who knows how to bring up a chart on a computer and perhaps little else - is back pushing the prices up again. Each day I wake up wondering what new, desperate, hair-brained idea the non-capitalist governments [which unfortunately includes Australia now] will come up with next to entice these gambling share buyers back into the market! If the government wants to interfere you would think that they would have the nous to discourage this casino-like, non-rational investment style or at the very least wait until prices are fairly valued before encouraging reinvestment rather than just doing anything to stop the market from falling. I fear the Aussie government -no longer, if they ever really were, the fiscal conservatives they stated they were before the election - with its increased first home buyer's grants, cash splash and ridiculously low interest rates are sucking fools to their destruction in an even worse crash in the near future, I'm sure they hope after they are reelected . Let us never forget that in 2003 the US hyped the share market with too low interest rates and caused a boom which suckered in many uneducated share and real estate investors and now, despite saying that they would be more responsible in the future at the G20 they and Australia are finding new ways to 'goose' the markets without, it appears, a rational method for valuing the share markets at all. Rising - good, falling - bad. I would be happy for the members of the blog to respond to these ideas and here's hoping the markets see the error of their ways and soon return to fair values to allow the patient and analytical value investors, we are, to do the job we do best which is to stop markets falling to irrational levels.
You touched on it there, Ben, and I think the first homebuyers' grant could be setting up another wave of disappointed/financially strapped people down the track. This one is insidious because people are taking their $14,000 or $21,000 and leveraging it many times over. If the resurgence in lower-end property prices turns out to be unsustainable, then we're likely to have another 'crisis' on our hands in a few years' time as many people grapple with the debt they lathered on top of their government handout. This problem would likely be accelerated/magnified if unemployment really spikes.
I have been a big bad bear on the property market for many years now (before it became cool - and yes I am a homeowner) and was flabergasted when the govt increased the FHOG. I (like most others) feared this would only make the bubble worse and this does seem to be the case. I work for a big four bank and I'm appalled at the amount of debt some people are taking on right now with interest rates so low and "properties affordable" apparently. It is not uncommon at all to see clients taking on debt of 6-7 times income as this amount of debt is now "affordable". Needless to say these people are the ones who can least afford it also and are very uneducated about valuing assets. I agree that this will make any eventual bust massive for these clients but nothing will change until the banks wake up and realise that lodoc lending is really dangerous to them and the borrower. In saying all the above, I'm now starting to see how property prices may not actually fall hugely now. The govt is obviously aware of the bubble and seem to be taking steps to reduce the effects of unemployment with the new 12 mth repayment holidays recently introduced. Perhaps, with this holiday period we may just avoid a catastrophic housing collapse as people wont be forced into placing their properties on the market (at least not straight away anyway). Combine this with the likely inflation in a few years and avg house prices may not fall too much and stay relatively flat for the next 5-7 years or so. This will give real house prices time to come back into the 3 to 4 times avg income band. Perhaps I'm dreaming but this outcome would be far better than the US/UK outcome you would have to think.
This is particularly insideous. We (as baby boomers) are trying to find a way to prop up real-estate prices. The next generation can't afford our houses so we dip into the public purse (future generation debt) for the $14 or $21k plus the stamp duty break (worth another $30k) - increased govt deficit. This is not sustainable. We are not only left with the increased govt debt but also the possibility of it all ending in tears when the overgeared first homebuyer loses the job and finds interest rates rising.
Here's hoping we will SOON see a "subtle shade" MORE blackness than we saw a few months ago. Otherwise I fear the the faint light at the end of the tunnel will be mocking us for years to come.
I think its all down to fear vs greed at the moment and for me, the last month or so has been a great time to buy when the mood is down and sell when it picks up. The pessimism will generally return in a week or so to do it all again, and if a paritcular stock takes off, there are heaps of other opportunities still out there. The keys are patience, a bit of luck, some diversification, not being too greedy, no gearing and keeping one of Kerry Packer's favourite sayings in mind- ä big bet is one you cannot afford to loose". Unfortunately (or fortunately), any new share purchase at the moment is a bet- and no one wants to be the prim and proper virgin left on the shelf when, and if, the market takes off. So get in, get dirty, and hopefully get out again. And do it all again the next day, week or whatever until it all comes crashing down again, at which stage you either buy big if you got out early, or hang in there and survive, doing quite nicely on your diversified, high dividend paying securities, until your market recovers.
To continue my point about the accounting deception in US banks, here is a recent quote from U.S. economist Nouriel Roubini : “In brief, banks are ...not properly provisioning/reserving for massive future loan losses; they are not properly marking down current losses from loans in delinquency; they are using the recent mark-to-market accounting changes by FASB to inflate the value of many assets; they are using a number of accounting tricks to minimize reported losses and maximize reported earnings; the Treasury is using a stress scenario for the stress tests that is not a true stress scenario as actual data are already running worse than the worst case scenario.” Therefore to me the current rally, seems a bear market rally - a triumph of short term trading over long term investing value and the green shoots Obama speaks of are the weeds of government encouraged self-deception.
Well said Ben!
This is a corrupt rally fuel by the financial oligarchs.
Forget mark to market,forget low reserves for bad loans and grap as much bail out money as possible.
The government approves it all!
Shaft the taxpayer with toxic assets.
Stephen Johnston
Dont worry Stephen , market will crash eventually when the truth reveal .
Greed will lead to destruction.
Regarding the stress tests for US banks and them being too optimistic in their stress scenarios... this just in ...
The baseline forecast for the stress test being used by the US and to be released on May 4, projected a 2 percent economic contraction and an 8.4 percent jobless rate in 2009, followed by 2.1 percent growth and 8.8 percent unemployment in 2010.
An “alternative more adverse” scenario had a 3.3 percent contraction in 2009, accompanied by 8.9 percent unemployment, followed by 0.5 percent growth and 10.3 percent jobless in 2010.
These 'tests' are already less severe than today's conditions -as economic output fell at a 5 percent annual pace in the first quarter, according to the median estimate in a Bloomberg News survey, the unemployment rate rose to 8.5 percent in March, a 25-year high, and the amount of industrial capacity in use fell to a record low of 69.3 percent and many commentators ie-Siefers believe “People are starting to view double-digit unemployment as a foregone conclusion.” ...
It appears that this 'stress test' is more calculated deception by the government and the banking lobby.
It is very disappointing that knowledgeable value investors and financial commentators are not warning the less knowledgeable, but the share market is designed to separate fools from their money and give it to the more knowledgeable... which is why value investing could be called knowledge investing!
Here is some relevant and interesting info, about the crux of the GFC ie the banks - that seems balanced - by Edward Harrison, who is a banking and finance specialist at the economic consultancy Global Macro Advisors focusing on global economics and corporate strategy. Previously, he was a Partner at the consultancy Lion Strategy Advisors, and worked in various consulting, strategy and M&A roles at Deutsche Bank, Bain Consulting, the Corporate Executive Board and Yahoo. He holds an MBA from Columbia Business School and completed his undergraduate studies with a degree in Economics from Dartmouth College.
He states...
This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks’ inherent insolvency becomes a problem. This means the banking system will remain weak even after recovery takes hold. The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off. Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.
The real situation In truth, the U.S. banking system as a whole is probably insolvent. By that I mean the likely future losses of loans and assets already on balance sheets at U.S. financial institutions, if incurred today, would reveal the system as a whole to lack the necessary regulatory capital to continue functioning under current guidelines. In fact, some prognosticators believe these losses far exceed the entire capital of the U.S. financial system. Witness a recent post by Nouriel Roubini:
The RGE Monitor new estimate in January 2009 of peak credit losses (available in a paper for our RGE clients) suggested that total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding would be at their peak about $3.6 trillion ($1.6 trillion for loans and $2 trillion for securities). The U.S. banks and broker dealers are exposed to half of this figure, or $1.8 trillion; the rest is borne by other financial institutions in the US and abroad. The capital backing the banks’ assets was last fall only $1.4 trillion, leaving the U.S. banking system some $400 billion in the hole, or close to zero even after the government and private sector recapitalization of such banks and after banks’ provisioning for losses. Thus, another $1.4 trillion would be needed to bring back the capital of banks to the level they had before the crisis; and such massive additional recapitalization is needed to resolve the credit crunch and restore lending to the private sector.
Now, obviously, if we were to face up to this situation, there would be no chance of recovery as the capital required to recapitalize the banking system would mean a long and deep downturn well into 2010 and perhaps beyond. This is not politically acceptable as 2010 is an election year. Nor is the nationalization of large financial institutions acceptable to the Obama Administration. Moreover, bailing out banks to the tune of trillions of dollars while the economy is in depression is equally unacceptable to the American electorate. The Obama Administration is keenly aware of this fact.
These constraints, some artificial and others very real, leave the Administration with limited options.
Engineer recovery With the preceding constraints in mind, we should remember that the first priority of elected officials in Washington is not necessarily to make the best long-term choices for the American people, but rather to get re-elected in order to have the opportunity to make those choices. It should be patently obvious that a downturn which began in December 2007 would be fatal to many politicians if allowed to continue well into 2010. This is why recovery of some sort must take place before that time - irrespective of whether it is sustainable.
How to engineer recovery is another question altogether. Here again there are a set of political constraints which make things more challenging. First, there are large swathes of the population that are uncomfortable with the huge debt load and deficit spending that a stimulus-induced recovery creates. Moreover, a government-sponsored nationalisation or recapitalisation plan would only increase this deficit spending and these debts.
As a result, the Obama Administration has crafted a plan to circumvent these obstacles.
Moderate fiscal stimulus. The Obama Administration decided not to seek massive stimulus earlier this year because they deemed it non-viable politically.This clears the first obstacle: deficit hawks. Most economists understand that the output gap that has opened up in the American economy is $2 trillion or more whereas the Obama stimulus package was only $800 billion. That leaves a massive hole in output in the U.S. Moreover, the immediate effective stimulus is less. Much of this ’stimulus’ will be saved or will not come into play until months from now. Obviously, this is not going to meet the grade (See my comments on this from February).
Quasi-fiscal role for the Fed. Having partially assuaged deficit hawks, Obama still needed to close the output gap. Enter the Federal Reserve. You will have noticed that the Federal Reserve has added legacy assets as eligible for the TALF program. In effect, this allows banks to slip tens or even hundreds of billions of dollars in so-called toxic assets off their balance sheets. Mind you, these are assets already on the books impairing banks’ ability to loan money. Under normal circumstances, one would expect the Federal Government to take these assets out of the system (bad bank, good bank, nationalization) after being given legislative approval to do so. However, as I have previously stated this approval is not going to be forthcoming. This is why the Federal Reserve is taking these assets on. In so doing, the Federal Reserve is taking on a quasi-fiscal role that re-capitalizes the banking system in order to stimulate the economy by increasing credit availability.
Quasi-fiscal role for the FDIC. The new PPIP is a similar end-run around Congress. After all, the role of the FDIC is that it “maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.” Meanwhile, the PPIP has the FDIC guaranteeing dodgy assets in a massive transfer of wealth from taxpayers to banks and select investors. (See my previous comments on this issue).
End of mark-to-market as we knew it. You should have noticed that most of the assets written down in the past two years have been marked-to-market. Securities traded in the open market are marked to market. Loans held to maturity are not. This is one reason that large international institutions which participate in the securitisation markets have taken the lion’s share of writedowns, despite the low percentage that marked-to-market assets represent on bank balance sheets. But, this should end because of new guidelines in marked-to-market accounting. However, the new guidelines do have two major implications. First,there are still many distressed loans on the books of U.S. banks that if marked to market would reveal devastating losses. Second, there will also now be many distressed securities on bank balance sheets that if marked-to-market would reveal yet more losses. In essence, the new guidelines are helpful only to the degree that it prevents assets being marked down due to temporary impairment. If much of the impairment is real, as I believe it is, we are storing up problems for later.
Interest rate reductions. One reason often given for a large increase in writedowns at financial institutions had been the coming reset of Alt-A adjustable-rate mortgages in 2009. With the subprime writedowns mostly accounted for, a souring of the much larger pool of Alt-A and Prime residential mortgage loans is the real Armageddon scenario. Well, part of this problem has been temporarily relieved because the Federal Reserve has reduced short-term interest rates to near zero and has begun trying to manipulate long-term interest rates lower by buying long-dated treasury securities.
Bank margin increases [%5 in US but only 2% in Aus]. Key to the whole program is banks’ ability to earn massive amounts of money and re-capitalize themselves through retained earnings as opposed to shedding assets or receiving additional paid-in capital (see post from last April on these three methods of recapitalizing). The market for bank assets is distressed and few banks can get enough capital from private sources or investors. Therefore, Obama’s plan hinges on the ability to allow these banks to earn shed loads of money as quickly as possible. If the banks cannot do this, we are going to have a big problem very quickly (Of course, I think the can).
The stimulus to come from these measures is still in the pipeline and, by the end of this year, will probably add a big kick to the economy. You should note that only the fiscal stimulus required legislative approval. All of the other ’stimulus’ has been done without Congressional approval and largely without Congressional oversight. These activities have been specifically designed to be opaque. The government’s claims of wanting to increase transparency ring hollow (see my post on Bloomberg’s suit against the Fed as an example of what is really happening).
I should also mention that the Federal Reserve has been a large factor here. It is acting in concert with the executive branch in a non-arms length fashion which I believe will have consequences regarding Fed independence down the line.
Other positive economic factors
-There are a number of so-called green shoots (a phrase coined by Norman Lamont) of note.
-Jobless claims have plateaued and comparisons to last year are actually declining (see post).
-The U.S. trade deficit is declining significantly as U.S. import demand has fallen off a cliff.
- Inventory liquidation will put U.S. manufacturers in a better position by Q4 and help make quarterly and yearly comparisons favourable.
I linked to the first two bullets of these other factors. And I wanted to spend a little time on factor number three because I think it is important. Niels Jensen of Absolute Capital Partners has a very solid write-up on this in his most recent newsletter:
Turning my attention to the global economy, after a rather muted beginning, manufacturers around the world have now begun to react aggressively to the economic downturn and inventories are falling aggressively. Chart 5 below depicts US manufacturing inventories as published recently by the Census Bureau. Inventory changes can have a meaningful impact on GDP. There is one example from the 1981-82 recession where the inventory correction subtracted 5% (annualised) from GDP in just one quarter. The current inventory correction is very negative for GDP in Q1 and possibly also in Q2, but it is very difficult to quantify the effect it is going to have. We will have to wait and see.
However, as we must remind ourselves, the stock market is not trading on what is going to happen in Q1 and Q2 of this year. Projecting at least 6-9 months ahead, the stock market is probably already looking ahead to Q4 and possibly even Q1 of next year. And the inventory adjustment currently underway is very bullish for GDP growth later this year and into next. The reason is simple. Manufacturers always overreact. Come Q3 or Q4, they will suddenly sit up and realise that inventories have fallen too much and that they need to produce more. There is no reason to believe that this recession will be any different.
Obviously, this means that U.S. Q1 and perhaps even Q2 GDP will be very low due to the subtraction of inventories now being purged. However, when we get to Q3 and Q4, this effect will be gone and quarterly and yearly comparisons will look favourable. So the inventory purge may mean a huge upside surprise to GDP in the second half of the year and early 2010 - potentially enough to see positive GDP numbers.
A brief reminder of what lurks beneath Despite the positives from the previous section, there are significant headwinds which may even preclude a positive GDP number. They include:
-Rising joblessness
-Increased savings as households rebuild balance sheets
-Spending cuts by local and state governments
-Decreased capital spending by companies
-A calamitous GM bankruptcy
-Moreover, credit availability –and hence GDP will be constrained by numerous factors including the following:
-Declining home values
-Increasing foreclosures
-Commercial property writedowns
-Credit card-related writeoffs
-Junk bond defaults
All of this means that a cyclical rebound is not a foregone conclusion at all.
Tying the threads together You should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery that might begin as early as Q4 2009 or Q1 2010. How long or robust that recovery is remains to be seen. Moreover, it is still questionable whether we will get any meaningful recovery at all in spite of the ‘green shoots’ because the banking system in the United States is severely undercapitalised and more asset writedowns are coming due. This is a fake recovery underneath which many problems remain.
Nevertheless, [US] banks are going to earn a lot of money and that is bullish for their shares - at least in the medium-term. Yes, the stock market is overbought right now [and probably will fall]. However, if banks put together some decent earnings reports over the next few quarters, their shares will rise.
Furthermore, if the banks can earn enough, this cyclical recovery will have legs as banks will then have enough capital to resume lending and that is supportive of the broader market as well. It is still too early to tell how this will play out over the longer-term [especially regarding inflation and then rapid increase in interest rates and therefore another even worse drop in the sharemarket - refer Australian share market 1970-75]. For now, I am much more positive on financials, and somewhat positive on the broader market as well.
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