Before we are all swept away into total despair, let's take a step back and imagine what could get stocks round the world going up for a while. Before I start, bear in mind that I am a hedge fund manager, have been wrong on the severity and duration of this panic, and that at this moment I am close to shore. I have little risk on, in other words.
First, let me point out that by definition the bottom of a bear market has to be the point of maximum bearishness. Thus sentiment becomes a crucial indicator.
The systematic work that we do on measuring sentiment (and we monitor about 20 indicators for the US and a dozen or so for other equity markets) show very extreme and in many cases record levels of bearishness. Obviously not every indicator is at an all-time high, and in some the history is short - but the message is powerful. Furthermore, there is compelling evidence that investors, hedge funds, pension and mutual funds, and the public are not just talking bearish, they have raised astounding amounts of cash. I am chastened by the fact that all the data we look at are from the past 40 years, which was really just one great magnificent secular bull market of wealth creation marked by periodic bears that were opportunities to buy. No one knows what levels of pessimism were necessary to spawn the 40 per cent 1929 rally during a massive secular bear market. Nevertheless, I've never seen capitulation and despair like this. We must be pretty close to maximum bearishness.
Second, valuations are cheap. There's no point in going into an elaborate dissertation; it's an inexact science. Using the best historic measures, normalised earnings, book value, and free cash flow, stocks are very cheap, but not as cheap in absolute terms or versus interest rates as they were in the 1930s or at the 1974 bottom. Nevertheless, the 4 per cent dividend return on the S&P 500 exceeds the yield on the 10 and 30-year Treasury bonds for the first time in 50 years. If emerging market equities, where the growth is, at six to eight times earnings are not cheap I don't know what is.
Third, stock markets have been obliterated and are deeply oversold. Even dead cats bounce. The Dow has had the steepest decline since the 1930s, and the spread between the price and the 200-day moving average at 34 per cent is the greatest since July 19, 1932. The US market is down almost 50 per cent from its highs, Europe is off 55 per cent, and emerging markets 65 per cent with some unfortunates, such as Russia, off 70 per cent. History shows that even in enduring, secular bear markets there are not just 20 per cent bounces but usually one 30-50 per cent rally. We should be due.
As far as the economic fundamentals are concerned, investor and consumer confidence have been ravaged by the sudden violence of the global recession. It is going to be deep and it may be long lasting. The bears say at best it will be like Japan's slow death. At worst, it will be a replay of the 1930s. I think both these outcomes are highly unlikely. The so-called authorities have learned from the policy errors of the past, and the response this time, while not perfect, has been faster and far bigger. The effects are just beginning to be felt. In fact, the stimulus has been unprecedented and there is almost sure to be more on the way beginning with the new Obama administration. The authorities seem to understand that they have to risk overkill.
And the fabric for economic healing is developing. In the US, average hourly earnings are rising at a 3 per cent annual rate and the consumer price index is probably declining at
5 per cent thanks to the fall in petrol, fuel and food prices, so real average hourly earnings are rising at a rate of 8 per cent. The savings rate is rising. The sharp collapse in the price of oil, while hurtful to parts of the world, is very beneficial to the US, Europe and Asia. The consumer spending collapse we are experiencing may be short-lived but that doesn't mean a boom is coming.
Finally, my guess - and it's nothing more than a guess - is that the deleveraging that has caused such heavy selling is two-thirds done. In listed equities it may be 80 per cent finished. Hedge fund redemptions are substantial and will continue into next year, but hedge fund liquidity is at a record high and hedge funds' gross exposure and net long is at a record low. Conversely, investor liquidity is at record high. All good contrary indicators.
If I'm bullish why am I not in there now? Because I would like to see the credit markets unclog and spreads come in more. At the bottom of a panic, the news doesn't have to be good for stocks to rally, it just has to be less bad than what has already been discounted. I want the markets to stop going down on bad corporate and macro-economic news.
The fact that it still does shows the bad news has not yet been fully discounted. I have no idea when the next bull market starts, but I do think we are setting up for the mother of all bear market rallies.
The writer is managing partner at Traxis Partners, a New York hedge fund, and the author of Hedgehogging
