As winter slowly gives way to spring, a positive change in confidence among investors has quickly emerged. Equity markets are enjoying a strong relief rally on a pace that is the fastest since 1938. In the 13 trading days since the S&P 500 Index closed at a new bear market low of 676 on March 9, the index rocketed 23% to close Thursday’s trading at 833. So, do these strong gains suggest the bear market is over? We remain highly skeptical that this rally is sustainable beyond the next few weeks, but we examine below both sides of the debate and suggest an investment strategy in this environment.
The initial spark for the rally was extreme oversold readings coupled with expectations for Congress to change mark-to-market accounting rules. Since Treasury Secretary Tim Geithner’s ill-received speech on February 10th, stocks fell 15 out of 19 trading sessions, setting the stage for a technical bounce. On March 23rd, investors cheered as the Treasury released details of its plan to deal with toxic assets on bank balance sheets. Adding further fuel to the rally, the government released economic data that was better than expected, including home sales, durable goods orders, and consumer spending. Finally, with the end of the first quarter of 2009 fast approaching, some portfolio managers may have experienced “performance anxiety”, buying stocks so as not to miss the rally.
To this writer, the recent rally looks dangerously similar to each of the previous bear market rallies that have failed over the past year. At the beginning of March, few people believed a rally was possible, and it seemed everyone was convinced the S&P 500 was headed to 600 at best. Now, with stocks 20% higher and economic data that is “less bad”, the media seems dominated by those expecting a new bull market driven by a second half economic recovery.
Perhaps the market has seen the lows and a cyclical bull market can continue. Yet to endorse this view, investors must make the aggressive assumption that actions by the country’s leadership have solved the financial and economic crisis such that this heavily indebted economy can return to growth later this year. This is an extremely tall order, especially considering the weaknesses of the plans. For example, the Treasury’s Public-Private Investment Plan to buy up to $1 trillion worth of bad assets leaves critical questions unanswered, including what price will be offered for the assets, and whether banks will be willing to sell at that price. Most disturbing, the plan relies on more debt to solve a debt-induced problem, which is akin to solving a drinking problem by ordering another round. Fundamental problems still remain, including weak bank balance sheets, too much debt, and too little capital. Our fear is that the plan will have limited success, and at a great cost to taxpayers.
The bull case lies in the growing confidence that trillions of monetary and fiscal stimulus dollars will gain traction. The Fed and other central banks around the world are pulling out all the stops, keeping interest rates low and buying mortgage-backed and Treasury securities. To be sure, the pace of the decline in economic activity appears to be slowing, as seen in this week’s housing data. The recent rise in crude oil and other commodities also supports this case. This improvement is likely just a bounce from the truly horrendous data from the fourth quarter of 2008, but nevertheless we must watch for signs of a sustainable trend. Finally, if we can make the argument that earnings are close to the trough for this cycle, valuations are attractive.
So while we continue to believe this is a bear market rally, we are watching several indicators as a signal to change our view. First and foremost, the credit markets are not confirming the rally in equities, so we would like to see corporate credit spreads to Treasuries narrow. Second, outperformance by emerging market equities, cyclical stocks, and commodities would signal a return to global economic growth and an improved appetite for risk. Finally, we would like to see the rally extend to broad groups of stocks and a decline in measures of volatility.
What is an appropriate investment strategy amid this market uncertainty? Our recommended allocation for long term investors who can tolerate risk is 30% equities, 30% high quality fixed income securities, 30% alternative investments, and 10% cash. Due to our expectation that the market will remain in a broad range and stock selection will be critical, we are biased towards active managers rather than indexing. Given the strong rally, we prefer to average in to the equity allocation on weakness. Should some of the aforementioned indicators materialize, we would become more aggressive with respect to the equity allocation.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.
Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.