Will a Bear Shit in Your Woods?

In April/May financial pundits began speaking of a Bear Rally, the subject doesn’t seem to be getting as much attention these days but it should. If the rise in the Dow and S&P are any indications of where the market’s head is at, we’re in for quite a disappointing surprise probably by the end of the year. Why so glum you ask? The Dow is up close to 50% since its recent bottoming out at 6,440 in early March. On Friday, August 28 the Dow closed at close to 9,550. The S&P 500 has followed a similar path, rocketing up from 667 in March to 1,030 on 8/28. When a major economic indicator jumps 50% in under six months the first thing an autodidact economist asks himself is “Where’s the party?” Under current economic circumstances, watching the Dow or S&P reminds me of the confused Jeff Spicoli when he is summoned back to Mr. Hand’s class from the vending machines. As Spicoli enters the class shirtless with a pair of Vans hanging around his neck and a bagel wedged in his jeans he says “Wait a minute, there's no birthday party for me here!” Today friends, there are many professionals in the world finance and economics who have that Spicoli vibe.

If the market is up on the premise that things aren’t getting worse, it’s understandable that we would see a few jumps once in a while as the long term trend adjusted to what will most likely be a protracted recovery. But 50% in less than six months is nutty. Employment, the 600 pound gorilla of economic indicators in a consumer based economy , is getting worse, profits have stabilized (not pulled out of a nose dive), and inflation, the equity slayer supreme, lurks like Charlie Sheen at a Miss Teen USA pageant.

This year’s stock market run, my friends, has all the markings of a bear rally. InvestorWords.com defines a bear market rally as “A rally in stock prices that is experienced after a significant downward trend. A bear market rally might indicate that the markets are turning around into a bull market, however it might also be a temporary reversal. Because it is so uncertain, it is also known as a sucker rally, due to the fact that many people might be persuaded to invest at the sign of an upward trend, only to see the markets fall again.”

Economists generally suck at predicting markets and amateur economists generally suck at being economists so the reader should take what follows as seriously as a North Korean arms control agreement.

In periods when good times begin to role the usual suspects responsible for kicking things off in a bull market direction are:
· Interest rate peaks with signs of lower rates to come
· Inflation peaks with sings of lower inflation to come
· A decrease in corporate or individual tax rates
· Increases in corporate profits
· Low stock valuation metrics (Price-to-Earnings, etc)

Currently, inflation and interest rates are near all-time lows, there are no tax decreases coming, and although corporate profits are beginning to edge up, stock valuations are still relatively high.

The indicators above, however, may not be the most important signs of whether or not your investment adviser will soon be eating Spaghetti O’s out of can. The ghosts in the machine are we humans. It seems we tend to like good news more than bad and tend to trust our instincts as much as or more so than data or facts. We all too often misread feedback and act to distort the loop. This helps to explain why millions of us keep pouring money into mutual funds each month or why even when no positive feedback is provided by the waitress at the 99 your buddy insists she digs him.

If more evidence is needed for the argument that the recent run up in equities is cuckoo for coco puffs one needs to look no further than the banking sector which has led the rally. As pointed out by Gretchen Morgenson in the New York times, a recent analysis of 7,000 banks shows that “the number of financially sound banks is declining and that the ranks of troubled institutions are growing”. Due to slowing business and write downs of bad assets many banks are barely holding on to solvency. Although there has been good news in the past few days from a few banks paying back some of their TARP loans, the number of banks receiving failing grades for financial soundness increased from the first quarter of this year to the second. Add to this the specter of a huge block of non-subprime loans coming into an adjustment period from low fixed rates to adjustable rates and it would seem the banking sector is in for a Bruce Willis style cab ride which will surely impact the wider market.

Finally, we shouldn’t discount the echo chamber effect that contributes to booms and busts. As Yale economist Robert Schiller has noted, the chatter and media attention that helped drive a panic sell-off of equities in late 2007 through 2008 has now done a 180 degree turn. The market has recently shrugged off bad news and risen on speculation of ‘green chutes’ and cautious optimism that things aren’t as bad as were told they would be. The so called 24 hour news cycle and the need to fill cable and talk radio programming with relevant content helps accelerate the echo and distorts the feedback loop. Further, it doesn’t help to have an army of assholes blogging endlessly about stuff they don’t understand.

Most of us don’t have the knowledge, information, or cajones to time the stock market but if you have, congratulations and get out. Take the nifty 50 you’ve made and put it somewhere safe. As the gloom and doom described by the flock of quacking pundits never materialized to the extent predicted (9.5% unemployment is Germany bad, not Zimbabwe bad) the good times will come slower and less substantially than the flock now quacks about.

Later…..