An amazing market rally. What’s next?

While yesterday was a very positive day in U.S. markets, with the Dow up over 300 points, the real action has been in Asia. The Nikkei bottomed at a 26-year low below 7200 on October 27th. Today, it stands at 9114.60. That is a gain of almost 27% in 5 days.

Gains have been noted across the board in markets across the globe, particularly in Asia and Europe. What does all of this mean?

To my mind it speaks to how oversold markets had become in October as we have just witnessed the mother of all relief rallies. A week before this rally, on Oct. 20th I wrote a post “Bullish,” that claimed we had seen a market bottom for the time being and that stocks were likely to trade up over the near term, particularly in beaten down sectors.

But, by no means should we believe that we are about to embark on an historic bull market. Back in June, I looked at economic growth and market gains as a proxy for bull and bear markets. This is what I said:

I have developed a long-term yardstick of market overvaluation and undervaluation. I have no short-hand for it yet so I’ll call it what it is: 10-yr. rolling average S&P 500 annualized returns vs. annualized nominal GDP growth. Now, that’s a mouthful. Let me explain what it’s supposed to show.

Basically, the stock market is a reflection of the inherent earnings capacity of the economy. As the economy grows, so do market earnings. As a result, one would expect the returns in the stock market to reflect the growth in the economy — at least over the long term i.e., 10 years. Unfortunately, that’s not how it works.

In the real world, stock markets become severely overvalued or extremely depressed depending on whether its a bear or a bull market. The reason is P/E ratios. During bull markets, they rise. In bear markets, they fall. And, as a result, the stock market simply does not reflect the underlying growth in the economy and earnings capacity of business — even over the long term.

That’s where my graph comes in. If the economy and the stock market grew at the same rate, one would see a relatively mild fluctuation in the comparison between the 10-year average returns in the market and in nominal GDP. Now, look at this chart.

That’s not what this chart shows at all. Comparing the S&P 500 index of the leading U.S. companies to the economy shows violent swings. In the last bull market, the differential was over 10%! That’s enormously overvalued. In the 1970s it was a differential of over -10%. That’s a severe undervaluation. Today, we have moved back into line — annualized returns on the S&P since 1998 are about the same as nominal GDP growth over that span.

My point here is not to pooh-pooh the recent stock market gains but rather to sound a note of caution that the future here is unclear. The graph above indicates that the S&P 500 may be about at fair value right now. However, markets do tend to move in cycles from over- to undervaluation and back again. This would suggest that we may have a number of years during which the stock market underperforms in the U.S. before we hit bottom.

Personally, I believe that we have seen a major relief rally. But, I do not believe that the bear market in stocks is over. I anticipate the market going much lower on an inflation-adjusted basis — either through large absolute declines or higher inflation or both.

Therefore, while I am bullish on some stocks and some sectors, I realize this market could turn on a dime — there is much more bad news out there to come in this business cycle. I remain cautious and I believe you should as well.

Your comments on how you see things developing are appreciated.