Beware the bear market bounce

The bullish momentum of global equities, which started a month ago, has extended into the first days of April. But the pace of the rally has made many investors worried that the claws of yet another bear trap are being sharpened.

“We’re not out of the woods by any stretch of the imagination,” said Andrew Milligan, head of global strategy for Standard Life Investments. “One only has to look at the pace of rising unemployment and what that entails for corporate profits in 2010 to remain cautious about the equity market.”

Major bear markets for stocks, such as 1973-74 or the decade-long bear market of the 1930s, were periods of extended rallies that ultimately failed. A bear market rally is often short lived and explosive.

Since leading markets fell to new lows for this cycle early in March, the bounce back has been led by financials, which had borne the brunt of selling pressure in February. This suggested that the rise in stocks during March was largely a result of what is known as “short-covering” – where market bears who had bet on stocks to go down by borrowing and then selling them take their profits by buying the stock back at the lower price.

When stocks fell sharply on Monday, it was mainly attributed to indications from the US government that it would not stand in the way of a bankruptcy filing for General Motors. It appeared that the March rally was in danger of following the path set by the so-called Santa Claus rally that began last November and which faltered at the start of the year.

Instead, stocks resumed rising for much of this week. The S&P 500, London’s FTSE 100 and Japan’s Nikkei 225 index posted their first positive month of the year.

March was the FTSE Eurofirst 300’s first positive month since last August.

This week, Hong Kong, Australia and the Nasdaq Composite entered positive territory for the year. In spite of declines on Friday, after sharp job losses in March, the S&P 500 was on course for its fourth consecutive weekly gain.

A run of weekly gains this long has not been recorded since the market peaked in October 2007.

Equities’ bullish performance was helped by signs that the pace of the decline in some global economic indicators was easing. Accounting rule changes for US banks and the marking of their distressed assets helped extend the rally for the S&P financials index, up 50 per cent from its low last month.

Another source of support came when world leaders at the G20 meeting in London pledged $1,000bn to the International Monetary Fund to cushion the global recession for emerging markets.

Indeed, emerging markets have been leading the charge in 2009. Moscow is up 19 per cent for the year, Shanghai has jumped 33 per cent and Brazil has rallied about 16 per cent.

This type of leadership is worrying some analysts. “In general, sustainable post-bubble rallies are not led by those stocks which are the bubble darlings,” says James Montier, strategist at Société Générale.

“The prominence of emerging markets, mining and financials in the recent rally gives me pause for thought. Especially when neither emerging markets nor mining are at bargain basement levels of valuation.”

At its current level, the S&P has rallied 23 per cent from its March low, a little less than the 25 per cent rally from its November low. The FTSE 100 bounced 23 per cent from its low in November and has risen some 15 per cent in the current rally. Japan’s Nikkei 225 index has gained 24 per cent in the past few weeks, better than its 20 per cent rally from November to January, but less than its 33 per cent bounce last October.

Ashraf Laidi, chief market strategist at CMC Markets, says past major bear markets, including two separate bear markets during the Depression of the 1930s and the dotcom bust of 2000, ran for three years.

“Such analysis suggests a bottom may not be reached until autumn 2010,” he said.

Making the valuation case for some markets is also difficult, say analysts. “Valuations are cheap, but they are not as cheap as seen in past,” said Mr Milligan, noting that the price-earnings ratios for the FTSE fell below 5 in the 1973-74 bear market.

In contrast, valuations for Japanese stocks looked very appealing, said Mr Montier.

“The entire Japanese market is trading below book value,” he said.

“Rather than running with the bubble redux, I prefer to hunt for opportunities where maximum pessimism is more blatant and the herd shuns the opportunities.”

The current rally in stocks has not been accompanied by a significant improvement in corporate credit.

Indeed, the corporate default cycle is on course to peak this year and instability could agitate equity markets, as was the case in 2002.

A significant headwind for equities also looms in the form of first-quarter earnings and guidance for the rest of the year to be revealed by companies this month.

Nicholas Colas, chief market strategist at BNY ConvergEx, said: “The past few weeks have been an ideal time for a rally, but the prospect of [the] earnings season will cap the market gains for now.

“Whether you are bullish or bearish, you have to be concerned about earnings and company guidance for the rest of the year.”