The treacherous nature of bear market rallies

However, I would be extremely careful in concluding that rising stock prices after a terrific decline, such as we had in the NASDAQ since March 2000, do signal improving business conditions. For a market, which has become very over-sold, it is only natural to rebound, but frequently these rebounds are merely bear market rallies, which are subsequently followed by vicious declines.

Probably the most famous bear market rally in history is the rise, which took place following the October crash of 1929. Stocks began to recover strongly following the November 13th 1929 low amidst wildly bullish comments and confident statements by a very large number of respected Wall Street personalities.

In fact, for a while the bulls were right. From a low at 199 on November 13 - down from the September 4, peak at 381- the Dow Jones Industrial rallied to a high of 294 in April 1930 (up 48%). This famous and well-documented bear market rally took place for a number of reasons. After the October 29 crash, the market had become very oversold - incidentally far more oversold than the US stock market's position on September 21, 2000. Thus, a technical rally was natural.

Also, the Federal Reserve Bank cut the discount rate immediately following the crash from 6% to 5% on November 1, 1929, to 4.5% on November 15, and to 4% on January 30, 1930. Subsequently the discount rate was repeatedly cut to 2.5% in June 1930, to 2% in December 1930, and 1.5% in mid 1931.

The interest rate cuts after April 1930 did, however, no longer support the stock market, which began to sell off once more. And by the end of the year 1930, the Dow Jones Industrial had broken below the November 1929 low and fell to 158 (from there it fell 41 in July 1932). Another reason for the 1929/1930 rally was that the economy held up following the October crash, which led a number of leading business and stock market personalities to make positive comments and to buy equities.

During the first six months of 1930, the business curve of the Harvard Barometer was almost horizontal and, therefore, did not signal a recession. Thus, the October 1929 stock market crash was widely regarded as a financial accident - a direct consequence of excessive speculation, but not as the beginning of an economic crisis that was to jolt the social and economic structure of the entire world.

No one anticipated a recession, let alone a depression. Charles Mitchell who headed the National City Bank, announced soon after the crash that the trouble was 'purely technical' and that 'the fundamentals remained unimpaired'. While President Hoover assured the American people that 'the fundamental business of the country, that is production and distribution of commodities, is on a sound and prosperous basis.'

US Secretary of the Treasury, Andrew Mellon also remained confident about the economy: On December 31, 1929, he stated: 'I see nothing in the present situation that is either menacing or warrants pessimism… I have every confidence that there will be a revival of activity in the spring, and that during this coming year the country will make steady progress' and in February 1930, he added, 'there is nothing in the situation to be disturbed about'.

Economists were not unduly alarmed either. Keynes said that the crash might be beneficial, as money, which had previously been used to speculate on stocks could now be diverted to more productive enterprise. Irving Fisher stated that the 'factors leading to the crash of the American stock market were not factors of depression but of prosperity, unexampled prosperity' and thought that stocks were 'ridiculously low' (subsequently they fell another 80%).

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.