Introducing the Less Worse Bull Market

"An optimist is the human personification of Spring" - Susan J. Bissonette

With Spring in full bloom in the metro area, and markets finally thawing from the credit crunch, this quotation seems extremely appropriate to welcome in the "It's Getting Less Worse Bull Market".

One week back from knee surgery, I'm still feeling some pain when sitting in front of a keyboard, so pardon me if the statistical back-up is a little lacking in this piece...but here we go. Corporate bond spreads have improved as you can see from the chart below comparing a High Yield ETF and the 10 Year Treasury.

The ABX Subprime Index has also rebounded as can be seen on this chart from Markit.com:

We know that the stock market has been acting much better, to the point that it has become extended - with nearly 77% of stocks above their 50 day moving averages (according to a recent Wall Street Journal article). It seems to be running into some corrective pressure, right where it should, at the declining 200 day moving average. In my piece Where is the Stock Market Headed? 200 Day SMA of February 4, I talked about the importance of this primary trend indicator turning negative, with specific reference to the rally that was under way at that time. I expected a retest of the lows of January at least. Frankly, with all the uncertainty at the time I expected the market to go appreciably lower. We got our "re-test" in March (getting back to the prior lows), and passed a financial market crash test (the Bear Stearns debacle) with flying colors. In the past, I have mentioned Ed Hyman and Nancy Lazar of ISI Group, and it is through Ed and Nancy that most every investor on Wall Street has learned that a wipe out of a major institution takes place at the crescendo of most every major financial crisis from Penn Central to Long-Term Capital, and that the stock market usually does much better once the poster child institution goes tapioca, as it encourages the Fed to bring out the big monetary guns. This has certainly been the case this time around, with the S&P 500 rocketing over 12% off the Bear Stearns low of 1260 to around 1,420 last Thursday. While the 200 day moving average is still negative and should continue to exert some downward pressure on the market, it is starting to flatten and I would not be all that surprised to see the market "break out" above it in the next month or two, signaling for many expectations of a more durable bull market.

So with all these emerging May flowers, one would have thought that the showers would be over with? It's easy to dwell on the continuing massive writeoffs and capital raises we are witnessing, including a small sampling here, here, and here. While the rating agencies' swords of damocles continues to hang over the mortgage insurance companies they continue to be forceful in their protest that with the latest capital infusions they will survive, as triple A rated credits no less.

The magnitude of the funds raised is pretty mind boggling. One wonders why investors are buying this new paper, if they don't expect some kind of rebound, as opposed to just an end to the bloodshed. Maybe playing the trade back to more normalized price to book values even on lower book values is enough for these players, who now see the risk of bankruptcy for financials as being behind them due to the implicit Fed put. My guess is that some players anticipate reversals of the current mark to markets at some point down the road, and see a big rebound in book value for their favorite horses in the race. It's possible, I guess, although for the most part we keep seeing default rates on various debt securities getting worse on not better.

Tom Brown of BankStocks.com has done a masterful job explaining why losses on 2006 sub prime loans will be less than expected, check out the pieces here and here. If he is right and his analysis is hard to fault, then the market's perception of the depth of the losses got over-done....basically the norm in these types of crises. Despite this, my guess is that the returns to be garnered on much of the capital raised to offset these losses will be low in general.

Just a brief anecdote illustrating why I believe this. I was speaking to a bank official for a large regional bank about assets the bank might have that are marked for disposition. The bank has experienced significant loan impairments already and has had to raise additional capital. The official noted that they were bringing in a new head of "special assets" to deal with disposing of bad loans and real estate owned (they don't have much real-estate owned today, but he admitted that they certainly would end up owning a lot more in the future). They wanted to put off discussions regarding disposing of non-performing assets until this new gentleman got up to speed, would not be selling any assets at fire sale prices and if they had any assets that were train wrecks they would hold them for their own account until they rebounded. In the intermediate future, they would dispose of some assets at a discount, but would not start the process until the commercial real estate markets had stabilized, which would depend on stabilization of the residential sector, which they were not seeing yet. I certainly sensed no panic on the part of said bank official, and no real urgency to act. Frankly, having been taught that your first sale is usually your best sale, I personally would not be putting my equity capital into the stock of a bank that was not trying to aggressively clean-up its books today - cleaning up responsibly and not in a fire sale, but cleaning up nonetheless. Although our banks have not totally ignored the bad debt issue as the Japanese banks did a decade ago - possibly because to marked to market accounting has not allowed them to - I get the feeling that the fed put and abundance of capital willing to re-liquify these institutions has destined us to a long, slow grinding re-adjustment, rather than a band aid pull-style quick turnaround in lending markets and commercial real estate prices in regions of the country that have over-supply problems.

Meanwhile, the economy overall seems to be holding onto its expansionary ways, if only by a thread. Residential construction hasn't helped the economy in a couple of years and the hurt has likely peaked. Commercial construction will slow but not crash. Domestically, large corporations employ only those deemed critical to be located in the U.S., so the slowdown is unlikely to result in massive U.S. job losses. Overseas markets are slowing with a lag and demand for our now cheap exports may be tempered, but probably not de-railed. The consumer, who constitutes 70% of the economy, is muddling through and reallocating spending to health care and education - the two positive growth sub sectors in the economy which are driving continued services economy expansion. So if a sub prime debacle, recapitalization of the financial system, raging food price inflation and $125 oil can't kill the economy, what will? Without an exogenous 9/11 type event, we may just be hitting bottom in the economy, until a new presidential administration gets the opportunity to make some bad policy choices some time in 2009.

So what does all this mean? In four words, It's getting less worse. While there are still tons of losses to be counted, and probably lots of capital to be raised to cover these losses, future bad news looks like it won't surpass recent bad news. The numbers might conceivably be equal in size, but the capital cushions being put into place and fed backstop facilities make it appear that future holes in the dike will not cause a collapse of the entire system. People are losing their sense of fear and are beginning to take risks again. My feeling is that their returns for this risk will be low, but hey, fed funds are negative on a real basis, so how much of a positive return can one expect to make anyway?

Less worse - that is what the coming bull stock market will be all about. It won't be about growth, which I predict will take several years to recover. But the stock market has done well in other periods of low growth. This time the cloud of incipient inflation and ultimately higher interest rates may restrain equity returns, but the worst could be behind us, which will cause pain to bull fighters and remaining sleeping bears.

Just to really test my hypothesis I checked in with my old buddy Stan Weinstein, technician extraordinaire. Stan has been telling his clients that he is intermediate term tepidly bullish. He thinks the market could exceed the S&P 500 1430 level and Dow Jones 13,135 level resulting in a big short squeeze, soon. Or it could fail to do so and correct for a month or so. Either way he doubts we are going to new lows and sees a selective bull market developing in the second half. Unfortunately, he thinks the coming bull market will grade a B- and we are set for several years of sub par stock market returns.

In the meantime, business around town is slow and getting slower and the mood may continue subdued even as the market breaks above its 200 day moving average. But a better stock market is "less worse" for New York real estate. Take it for what it is, not a huge vote of confidence, just a factor that may start to augur better for the moods of potential buyers as we head into the dog days of summer.

Other Less Worse Thoughts on The Stock Market From The Blogosphere:

A Peak at Pimco's Long View

Merrill To Crank Up Sell Ratings - Major Contrary Indicator

How to Thrive In a Barren Market

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