Teun Draaisma, the widely followed Morgan Stanley equity analyst who called for a crash last August, is at it again. Draaisma says the bear market is alive and well and stocks should be sold into the recent strength.
“We continue to prefer cash over equities as we have done throughout most of this bear market, and we continue to prefer earnings stability, strong balance sheets and low valuations. After the recent strength in equities, with European equities up 17% and the S&P 500 up 25% from their troughs, we now move 5% out of equities into bonds. Thus, our new asset allocation is +5% overweight cash, neutral bonds, -5% UW equities.”
“We expect further weakness (in U.S. housing), as does the futures market for the Case-Shiller index, which, like us, expects US house prices to trough by the middle of 2010, 50% lower from its peak on that index. The three main worries we have are the following. First, US house prices have never bottomed while unemployment is still rising: our US economists expect the unemployment rate to peak at 9.9% in 1Q10.”
“We have to decide whether this is towards the end of another bear market rally that we should sell into now that hope has grown, or the start of a much larger advance, maybe even a new bull market. Our decision is to sell into strength now.
“Our three signposts to identify the end of the bear market do not flash green. We wish to wait for fundamentals to be close to trough before turning more bullish. The three fundamentals we look at are: 1) earnings; 2) US housing; and 3) banks’ balance sheets. Our three preferred measures are: 1) reported return on equity ex financials below its long-run average of 12.8% (latest 17.4%); 2) inventories of unsold homes below 8 months of sales (latest 12 months); and 3) senior loan officer (SLO) survey better than -20% of SLOs tightening lending standards (latest -64%).
“Other reasons to sell: after the biggest valuation overshoot ever, in 2000, we have not had a meaningful valuation undershoot. Weekly unemployment claims have continued to rise. Some fixed income markets have
fallen to new lows even recently.
“Where could we be wrong? Our move today could easily be too early as the rally could continue for positioning and ‘second derivative’ reasons. In addition, if policy action is successful in repairing banks’ balance sheets and putting a floor under house prices, the next bull market may have already started. Two of our signposts – the SLO survey and inventories of unsold homes – would tell us at some point that we have missed the turn and we should stop being bearish.”
“Credit markets have been lagging in this rally, which has been very much equity-led. The futures market of house prices in the US, the RPX index, has continued to fall in recent weeks, indicating a lower trough despite the policy initiatives. Our US economists point out that what had been only a meager rebound in the subprime ABX market following the Treasury’s legacy asset purchase plan announcement has now reversed all the way to new lows. They also point out that the AAA index in the commercial mortgage CMBX market has now widened to 637 bp from the recent lowest spread of 525 bp hit last Thursday, moving about halfway back to the 747 bp close on March 20.”
“We are currently in one of those classical 20%+ bear market rallies on the hopes of successful policy action. For instance, in the US between 1930 and 1932, there were five 20%+ such rallies (up to 35%) lasting 35 days on average. We hear people use adjectives such as biggest, strongest, fastest and other superlatives to describe this rally. We believe this is quite a normal bear market rally. What would be more painful is a 6 or even 12 month move of over 50% as happened a few times in Japan. The current one has so far been 25 calendar days, and 25% in the US, 17% in Europe. Anyway, with the S&P at 843 closing in on its 150-day moving average of 900 (200-day moving average of 992) we feel the risk-reward of further upside is not compelling.”
Of course, readers of TPC have known all of this for weeks as I have been pounding the table on the points above throughout the rally that we called for on March 9th.
Update (2:00PM) –
To wit, he sees three outcomes – two of which are downright scary:
- Successful policy intervention
- Bankruptices and defaults
- Debt deflation and the passage of time
The first outcome, Draasima sees as implausible.The problem with the successful policy intervention scenario is that we doubt policy action can be successful in a short period of time, especially if much of the policy action focuses on spending more and saving less. It may be that there is just too much debt in the system; that a debt transfer from the private to the public sector is too large and that governments cannot finance it without rising financing costs; that time is the best healer, and that there is no quick fix or magic bullet. Also, with every solution that is presented as a magic bullet that ends up not working, the chance of success of the next magic bullet is lowered, because the crucial element of confidence slowly disappears.Which leaves two and three.The second scenario would results in equities hitting significant new lows.In this equity market scenario à la 1929-32, markets become victim of the realisation that authorities have tried everything to stabilise the situation rather quickly, but in vain, and that at some point there are no policy bullets left. This results in a deepening of the current global synchronous recession. The debt problem reduces through mass bankruptcies or defaults. Thus we may now be what is the equivalent of 1931, in the sense that everyone knows about the bad news, and still markets will go much lower as the crisis deepens and authorities are not in control.As for the third, markets will go to new lows for years to come, much as happened in Japan in the 1990s.
In this debt-deflation scenario, the problem of too much debt is simply too big, and there are no magic policy bullets. Indeed, if we look at the US alone, debt over GDP in 2007 at 340% was much higher than the 185% in 1929, so the debt problem to start with was almost twice as big! At the depth of the Great Depression, US credit market debt-to-GDP had risen to 299% because GDP had fallen and most of the debt was still there, and it took all the way till 1951 before it bottomed at 130%. The presence of too much debt in private and public hands erodes confidence and risk-taking and thus growth and risk appetite will remain in the doldrums for a long time.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.