Getting bearish again

You have probably noticed a change in tone at Credit Writedowns since about June, but a lot more in the past month or so. Once mildly bullish due to the deeply oversold levels this Spring, I have become increasingly alarmed at the unjustified strength of the recent market rally.

My most recent post explaining my concern, “Major selloff coming?” kind of gives you the timeline. I really would like to be bullish, but I have major issues with this rally on both a technical and fundamental basis:

Technicals

1. The technicals all point to stock markets in the U.S., Europe and Emerging Markets as being overbought. This has been the case for at least two months now. As the market continues up without a pullback, you have to be concerned that any pullback will be violent.
2. There has been an enormous multiple expansion, which is usually what occurs in the middle to latter stages of a secular bull market, not in the beginning of one. It certainly makes one think this is a bear market rally and not a secular bull move.
3. I have said that the massive liquidity dumped into the system is not going to fuel inflation when capacity levels are at historic lows in the U.S.  There is absolutely no pricing power, either for businesses or workers. But, all that money is going somewhere eventually. Right now, it looks like it’s going into asset prices. Liquidity is seeking return.

Fundamentals

1. If you look at the deflationary pressures, they are almost all still at work: poor employment markets, producer price inflation at record low levels (Germany down 7.8% through July y-o-y for example), overcapacity in Europe, China and Asia, back breaking debt levels, etc, etc.
2. But, then, where is the demand?  It’s not there. The consumer is not going to be jumping in here. A lot of the uptick in the economy is inventory-related, not consumption-driven.  So either former exporters, government or business will have to pick up the slack.
3. And let’s not forget my favourite whipping boy, the financial sector. In the U.S., there are a lot of toxic assets on balance sheets, while leverage and equity capital ratios are still poor.  That speaks to the need for continued deleveraging and low loan growth in the financial services sector.

So while a snap-back rally was inevitable given how oversold things had become in March, this rally has been a bit over the top.  I am not alone in this assessment.  The Wall Street Journal has pointed to Jeremy Grantham and a few other March bulls who are now speaking in more cautious tones.

…Jeremy Grantham, penned a note on March 10 entitled “Reinvesting When Terrified” that encouraged investors to buy, suggesting stocks were 30% undervalued.

Since then, the market has roared ahead, without stopping for a correction of 10% or more. Standard & Poor’s 500-share index ended last week at 1026.13, up nearly 52% from its 12½-year low on March 9 and its highest close since Oct. 6. The Dow Jones Industrial Average is at 9505.96, up 45% since its March low.

Now, the chairman of Boston asset-management firm GMO and his colleagues say the S&P 500 has zoomed right past what they consider fair value of about 880, based on earnings estimates and historical price-to-earnings ratios.

Notice the part about not having had a correction, which I see as a contrarian indicator.  Back in May, Grantham said a leap up to 950 and then a sideways move between 950 and 1050 on the S&P meant the market was modestly overpriced.  That is not a sell signal. This is where we are right now. But, at 1026, we are dangerously close to breaking out of that range to the upside – which would be a sell signal.

With the City and Wall Street ready to return to full speed soon, we will get a better taste of what is to come due to higher trading volumes.  But, for now, I am mildly bearish on shares.