Is This The Beginning Of A Bull Market, Or Just A Breather For The Bear?

By Martin Hutchinson on April 16, 2009
Since sinking to a 12-year low of 676.53 on March 9, the Standard and Poor’s 500 Index (^GSPC: 856.93 +4.87 +0.57%) had risen 24% - the best such short-term rally since 1933. But this isn’t 1933 and you shouldn’t trust the rally. Happy Days are NOT here again, at least not yet.The 1933 rally came after a record-breaking decline. Real gross domestic product (GDP) fell by 25% during the Great Depression and the Dow Jones Industrial Index (^DJI: 8061.47 +31.85 +0.40%) fell by almost 90%.

What is less well known, however, is that valuations remained depressed for well over a decade after 1933. In 1949, when the Dow was selling at a price-to-earnings ratio (P/E) of just 7 times, it was cheaper in terms of earnings, net asset value, and GDP than it had been at its 1932 nadir.This time around, the S&P 500 index fell 58% from its 2007 peak to its March 9 bottom at the superstitiously significant 666. Of course, 58% is nowhere near as much as 90%. To recover from a 58% drop the stock market must rise by 138%, but it must rise by 1,000% to recover from a 90% drop.So it is not surprising that in spite of inflation and enormous economic growth, the Dow did not reach its 1929 level until 1954.The other difference between 2009 and 1933 is that the 2008 stock market peak was both higher and more prolonged than it was in 1929, which was a mere blip by comparison.

Radio Corporation of America - 1929’s equivalent of Cisco Systems Inc. (CSCO: 17.56 0.00 0.00%) or Google Inc. (GOOG: 379.50 0.00 0.00%) - never got above 28 times earnings in that market, and the Dow spent less than three years within 50% of its peak value of 381.17, only passing 200 in December 1927, and finally falling below that level in August 1930.In this market, the Dow was above 7,000 - within 50% of its 14,164 peak - continually from May 1997 until February 2009. Because the 2000s market was more overvalued for longer for a longer period of time, it has further to fall, even without a “Great Depression” economically.

The current rally has been based on signs that the U.S. banking system is not about to expire - a development I wrote about in an article entitled “The Top 12 U.S. Banks: From Zombies to Hidden Gems” in late February.Apart from the very largest banks, which gorged themselves on the most foolish and ill-designed products of the derivatives business, the banking system is suffering from a normal real estate downturn and is coping well with the high levels of loss that downturn has brought. With short-term interest rates well below long-term rates, banks’ ongoing lending business is currently exceptionally profitable.The U.S. economy, as a whole, has stopped falling with ever-increasing velocity and may actually be beginning a lengthy “bottoming out” process. Had politicians avoided meddling with the monetary and fiscal systems of the globe, devoting trillions of dollars to bailouts and stimulus, the bottom we are approaching might well be somewhat deeper, but we could at least be sure that it was indeed the bottom, with recovery to follow.

In Asian countries such as Korea, Taiwan and Singapore, where stimulus has been modest, and in China where it has created only a modest budget deficit, the sharp recession caused by collapsing exports is already coming to an end. (China, however, has a major banking and real estate problem that could still cause trouble down the road.)But in the United States, we can have no such assurance. Monetary policy, which was far too expansive in 1995-2008, reached expansiveness of extraordinary dimensions after last September’s crisis, with the monetary base doubling and broad money expanding at a rate of more than 15%. Fiscal policy has produced record peacetime deficits - deficits that are more than double the previous peacetime record. The Federal budget deficit in 2009 will be double the 2007 balance of payments deficit, which had previously been thought of as a critical and dangerous imbalance.

With imbalances of this size, there can be no assurance that a recessionary bottom will be followed by recovery, quite the opposite. Japan has now suffered near-recessionary conditions for almost two decades with a weak recovery in 2003-07. And that modest recovery is now being followed by a new recession as the Japanese government foolishly resorted to more wasteful public spending and debt.Fiscal stimulus stimulates nothing in a country where public debt is already 160% of GDP; instead it increases uncertainty and crowds out risk-taking private capital.The most likely scenario for the United States is a recession, or near-recession, that lasts for a decade with the economy unsuccessfully struggling against the twin problems of surging inflation and a budget deficit that crowds out private capital investment. Either real interest rates will be high to combat inflation or inflation will rage out of control.

In such an environment, the outlook for stocks is bleak. The high stock prices of 1996-2008 have gone, and they will not return. When the excessive monetary expansion began in the spring of 1995, the Dow was at 4,000. That is equivalent to a level of 7,800 today when you inflate it by the increase in nominal GDP since 1995.However, 1995 was not a bear market low. It was far from it. The market had been rising for four years since its 1990 bottom and was almost 50% above its 1987 peak, just before the “Black Monday” crash.

Thus, even if the economy had the growth prospects of 1995, a level of 7,800 on the Dow would be a reasonable expectation, not for a bear market low but for an equilibrium value. If you then take into account the markedly worse expectations for the U.S. economy resulting from excessive fiscal and monetary stimulus, 7,800 is too high.Take the 1949 P/E multiple of 7, and apply it to a recovering earnings level of say $60 on the Standard and Poor’s 500, and you get an S&P of 420 - equivalent to a Dow of around 4,000.The market is no longer hugely overvalued with the Dow at 8,000, but any rally will be temporary, and we can expect an eventual low well below the 6,547 the Dow reached last month.