Are the markets set for a pullback?

The U.S. stock market has been off to the races, since hitting a low in March.  The S&P 500 has skyrocketed a massive 34%, erasing all of the losses of 2009.  Is this a case of much too fast too soon?  And is this a bear market rally?

Before I tell you my thoughts, let me review some posts here tracing the uptick.

Back on March 5th, I asked “Is the U.S. stock market close to bottoming?” demonstrating that a number of bears like Bill Fleckenstein, Steven Leuthold, and Marc Faber had gone bullish. While I saw the potential for a short-term rally from deeply oversold levels – hence the question – I was and still am not a believer here in a sustainable secular bull market.  At the time, I said:

My own read here is this: markets tend to overshoot in both directions. This suggests that we will need to go well below fair value before this bear market is over. The price/earnings ratio on the stock market of 13 is near perceived fair value of 15 here. An overshoot could take us down to 500-600 on the S&P 500. Moreover, in 2007, corporate earnings as a percentage of GDP were at record highs, suggesting they were cyclically inflated, making those P/E ratios also inflated.

The long and short is I don’t think we are near bottom. We should see more downside before this bear market is over. However, I tend to think a bear-market rally is in the offing this year due to unprecedented stimulus. So, shorting might be as dangerous as Faber suggests, but indexing is equally dangerous. In the meantime, there are an increasing number of attractively-priced stocks out there as Faber, Fleckenstein and Leuthold can attest.

Basically, I said no, we are not at the bottom, but a bear market rally was overdue – at some indefinite point later.  Of course, 4 days later we did hit an (intermediate) bottom – not that my quote: “I tend to think a bear-market rally is in the offing this year” says I called it (this year does not mean 4 days from now).

In any event, this rally turned out to have a pretty good head of steam.  In the month after that, I became more bullish regarding this rally and said so in a few posts

like “Wells profit forecast is a clear bullish sign.”

Ultimately, the Wells profit announcement should make one believe that this rally is for real and, despite a potential decline due to an overbought position, can continue through to the Fall after a pullback.

To be clear, I think this is a cyclical rebound a.k.a fake recovery and it is also a massive transfer of wealth from U.S. taxpayers to banks.  But it is a rebound nonetheless and financials will benefit.

And, now there’s this whole recovery meme with a lot of data coming out better than expected.  I buy into the recovery, but the run-up in stocks has me worried.  Yesterday, I said:

Quite frankly, a 34% up move led by a weak financial sector, should give anyone pause.  I certainly called this last month.  However, the ferocity of the uptick is a bit over the top and makes me worried about downside risk.  Now that the stress tests are out and all is fine and dandy, thoughts about buying the rumour and selling the news come to mind. Let’s see where we get to over the next week.

So, where does that leave me now?  Thinking that we are overdue for a pullback.  Whether we are in the midst of a cyclical bull market is another story.  I say yes, probably.  Time will tell.

What do you think?

7 Comments
  1. aitrader says

    China no longer buying US treasuries.

    US deficit at a post-WWII record.

    Europe on the brink of freefall.

    2/3 of US mortgagess underwater.

    Global trade collapsing (check the Baltic Dry Index)

    Hmmm…..I may suck at timing but I can name the overall trend. Still down, down, down. The bottom has not yet been discovered. Folks buying into the rally will be cannon fodder IMO.

  2. Stevie b. says

    Ed – for the reasons given as well as those we’ve talked about before, I’m basically with Aitrader. I was hoping for 9000 on the Dow, but we know the fate of most pigs. If you’re right and it’s the start of some sort of cyclical bull market, it’s going to be based on smoke and mirrors.
    You cannot prop-up the unproppable-uppable.

    1. Edward Harrison says

      No bull market, huh? I knew I could count on you two to give the bearish scenario :)

  3. pwm says

    Defaults have not peaked. They probably have a way to go. Hard to see a bottom put in before that happens. And first derivatives remain pretty ugly. In the context of such weak financial institutions and such high levels of junky debt across the economy, this probably matters more than in past recessions.

    Also, I’d be interested in hearing your thoughts about how the US will ultimately delever. Debt to GDP is still growing and at unprecedented levels. Just the slow down in debt growth caused a major decline in GDP and employment. What will happen when we actually start to delever, and how will it happen? Jeremy Grantham laid out his expectation: more saving, debt destruction, and some inflation. What is your view on how we will return to sustainable levels of debt to GDP?

    1. Edward Harrison says

      pwm, CRE and prime defaults are serious headwinds going forward along with credit cards. If we can get through those (helped by a rebounding economy and fewer job cuts) I think we are in the clear.

      As for first derivatives, they all look much better than a few months back actually. I would concentrate more on third derivatives really i.e. how quickly is the change in economic variables proceeding. For instance, if the decrease in jobless claims is accelerating, then you can see this feeding through into consumption.

      Finally, with regard to Debt to GDP, I expect to write a post about inflation soon. My general thinking is that Bernanke is looking for inflation, seeking inflation, if you will. Inflating away debt may be the least worst option for policy makers and I think they are onto that already.

  4. Wag the Dog says

    “Rallying global stock markets will likely reverse trend later this year when weak earnings and economic news surprise investors, Nouriel Roubini, a well-known economist who predicted the credit crisis, said on Wednesday.”
    http://www.guardian.co.uk/business/feedarticle/8491922

    We can always count on Dr. Doom to spoil the fun.

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