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WILL THE LEHMAN VACUUM GET FILLED?

Credit spreads have normalized back to their pre-Lehman levels and the recession has officially ended.  Despite this the stock market remains well below the pre-Lehman Brothers bankruptcy levels.  In his latest strategy comment Jeff Saut says the year-end rally is likely to continue (he said buy the dip last week) and could even rebound to the pre-Lehman levels for a full 14% rally from here:

As for the equity markets, while we have wrongly been looking for a correction since the beginning of the fourth quarter, the S&P 500 (SPX/1069.30) still hovers around the same level it was when we turned cautious. To us that’s pretty bullish, for as stated in last week’s letter:

“While our sense is that we are into a secondary correction, our proprietary overbought/oversold indicator is VERY oversold and the number of S&P 500 stocks that are above their 50-DMAs has fallen from more than 90% to 33.2%. Consequently, we continue to think it is a mistake to get too bearish.”

Indeed, despite the “bad mouthing,” all stocks have done over the past month is consolidate their July – September rally by moving sideways. Moreover, that sideways consolidation has seen the equity markets work off their overbought condition into one of being pretty oversold. Ladies and gentlemen, to an underinvested portfolio manager the current environment is a nightmare, especially if you believe as we do that we are going to see an upside celebration into year-end. Manifestly, we have argued that with credit spreads below their pre-Lehman bankruptcy levels there should be no reason why the equity markets can’t “fill up” the downside vacuum created in the charts by said bankruptcy. As can be seen in the following chart, that gives the S&P 500 an upside target of 1200 – 1250. If correct, it implies that the cash rich, underinvested portfolio managers (PMs) will once again be forced to chase stocks higher. Our guess is the PMs will chase the “winners” since the March lows rather than buying the laggards. That suggests investments in emerging and frontier markets, technology, financials, base/precious metals, etc. should trade higher if the aforementioned scenario plays.

The call for this week: Time is running out for the bears if our year-end celebration is going to play. If the major averages break out above their recent reaction highs the party could commence. As for us, we are on the road again this week, so these will likely be the last strategy comments for the week.

We’ve heard this before though.  As we recently mentioned, Credit Suisse agrees with this idea that the Lehman vacuum could be filled:

The disparity between credit indicators at pre-Lehman levels and a market that is still 20% below Lehman levels.

The analysts note that many indicators are substantially better than they were before Lehman Bros. filed for bankruptcy and panic set-in.  Despite this, the market remains well below the pre-Lehman levels.  Specifically, interest rates have declined from 3.73% to 3.38%, ISM has improved from 48 to 58, and corporate BAA spreads have improved by 55 bps.  Despite this, the market remains well below its level of 1252 on the day Lehman filed bankruptcy.

In an attempt to play devil’s advocate I would note a few phenomena that likely justify the price decline since the Lehman bankruptcy:

1)  Real estate prices are 9% lower than they were on the day Lehman filed BK.

2) The total public debt outstanding has risen 25% to $12T (this is truly astounding).

3) The banking sector remains entirely unchanged (read, broken and strewn with moral hazard).   The problems that resulted in the credit crisis remain entirely unresolved.

4) S&P 500 revenues have fallen almost 15% from their Lehman levels

5) I am sure readers can add to this list on both the positive and negative side…..

Does the market deserve to be at its pre-Lehman levels?  Call me skeptical for now, but don’t accuse me of being bearish.  Only a fool stands on the tracks when Bubbly Ben is riding the Dollar Destruction Express!

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