The treacherous nature of bear market rallies (page 2 of 2)

To some extend, Fisher had a point. At its November low, the Dow Jones sold for only 10-times earnings after having peaked at 15-times earnings in early 1929. This was inexpensive when compared to interest rates of less than 4% on long-term government bonds - not to mention the current S&P 500 P/E of over 35!

In fact, these seemingly low stock valuations and sound economic fundamentals led several well-known investors to accumulate shares. Jesse Livermore, who in the summer of 1929 had sold short, publicly stated in November of that year that the decline had run its course and that he expected the market to recoup from its October setback.

Livermore subsequently lost all his money in the 1930-1932 decline and eventually committed suicide. John D Rockefeller who had not spoken publicly for several years, issued a statement in which he said: 'these are the days when many are discouraged...In the ninety years of my life, depressions have come and gone. Prosperity has always returned, and will come again...Believing that the fundamental conditions of the country are sound, my son and I have been purchasing sound common stocks for some days.'

Even Bernard Baruch, who had correctly anticipated the stock market collapse, later confessed: 'I never imagined, in these last months of 1929, that the collapse of stock prices was the prelude to the great depression. Anyone who knew the potentialities of the American economic system, as I had come to know them, could not help but believe that the market break would just inevitably be followed by an even greater prosperity.'

The point I should really like to emphasize is that rally phases after a serious break frequently lead to a false sense of security and confidence among the investment community 'that the worst is over' because stocks are rebounding strongly. Moreover, because business conditions do not deteriorate very badly during the first phase of a bear market, economists and well-known market observers remain optimistic about the future.

However, we all don't know if a strong rally after a sharp decline is a bear market rally, the extension of a secular bull market, such as occurred after the declines in 1987 and in 1998 or an entirely new bull market. But we ought to be careful in concluding that because US stocks have been rising recently, an economic recovery is just around the corner and that corporate profits will shortly begin to rise again.

We simply don't know how the world will look in a year's time. But it is clear that aggressive interest rate cuts, which led to the furious housing refinancing boom, and zero interest rate car loans have borrowed from future consumption, which will be curtailed once interest rates no longer decline.

Don't forget that following each recession over the last 100 years, in the initial recovery economic phase, interest rates continued to decline boosting stock prices and profits. Judged by the recent bond market action, interest rates will, however, go up even before this recession comes to an end.

Thus, given the S&P's still lofty valuation, I remain of the view that US equities have at present very best little upside potential and at worst, still significant downside risk. In fact, I lean toward the view - based on technical factors - that we may very well already have seen the recovery highs for the market or will see them in the next few days and that from here on the down trend will resume.

Indeed, for investors who really believe in a recovery, Asian stock markets, which in 2001 have begun to outperform the S&P and are by any valuation standards inexpensive, represent far better value. Don't forget that after serious market breaks it is common for the leadership to change.