We have an incredible bear market rally on our hands. History shows that these spasms can go further than anyone thinks. But after the U.S. market staged a monstrous 80-per-cent-plus rally from its March, 2009, lows (the most pronounced bounce in such a short time since 1955), it has become seriously overextended. Meanwhile, practically every pundit is extrapolating the recent trend into the future because that is the easy thing to do.
Most investors see only the recent returns; they do not see the nearly invisible risks. But the risks are there. I recall all too well the 2003-07 bear market rally - yes, that is what it was. It was no long-term bull run such as 1949-1966 or 1982-2000. It was a classic bear market rally, and it ended in tears because what drove the market upward was phony wealth generated by a non-productive asset called housing alongside widespread financial engineering, which triggered a wave of artificial paper profits.
Remember, returns only count if they aren't ultimately reversed by excessive greed. Right now, I believe clients are well served by equity strategies that focus on stocks of high quality companies and by investments in both hard assets and income-producing securities. Also good are long-short strategies (vital in controlling risk in the portfolio) and a concentration on fixed-income products (outside of commodities, deflation in the developed world remains the primary trend - against such a backdrop, searching for yield makes perfect sense).
As far as equities are concerned, the current bear market rally is likely at the very late stage. Few people will know to get out at the peak and as we saw in late 2007 and into 2008, many investors will be trapped in a falling market. Bear market rallies are not the same as secular, or long-term, bull markets - the former are to be rented, the latter are to be owned.
This is not the 1949-66 secular bull market, which was underpinned by troops coming home and spurring on a baby boom that would unleash years of tremendously strong domestic demand growth. The demographics in the U.S. are now downright poor - just look at the dwindling ratio of the working age population to the total population.
Nor is this the 1982-2000 secular bull market that began when the U.S. Federal Reserve ushered in years of disinflation. (The current Fed is trying desperately to create inflation.) That market floated higher on a wave of innovation that saw the mainframe, the personal computer, the Internet and then the cellphone transform many businesses. At the same time, a boom in the capital stock enhanced productivity growth and led to sustained gains in private sector economic activity, which by the end of that bull run allowed the government to actually start to record budget surpluses.
What is the major innovation today? The iPod? The iPad? Facebook? These may be fun, but they don't do much to promote the growth rate in capital stock or productivity.
What we have on our hands is an economic revival and market bounce premised on unprecedented monetary and fiscal stimulus. How the Fed and the U.S. federal government will manage to redress their swollen balance sheets without creating a major disturbance for the overall economy is a legitimate question. Under such conditions, the market does not deserve to trade at a double-digit multiple of earnings.
Just as the 2003-07 bear market rally was built on a shaky foundation of unsustainable credit and house price appreciation, the current bear market rally has been built on even shakier ground of surreal public sector intervention. This may well have "saved the system" or "prevented a depression" back in the opening months of 2009, as many like to believe. However, the reality (and even former Communist regimes figured this out a few decades ago) is that there is no such thing as a free lunch.
David Rosenberg