Bear Rally or Bull Market

Stock markets world over have rallied spectacularly since early March of this year. In India, the major indices have gone up 40-45% since the lows of March 9, 2009. In a matter of a less than 2 months, we have seen gains of over 100% in some large cap names as well, not to mention smaller companies whose share prices have gone up by even more.

The rally has caught most people by surprise. Just a couple of months ago, there was doom and gloom all around. With the Nifty at around the 2550 level, lower levels seemed imminent. But like always, the markets proved the consensus wrong and raced up to its current levels of 3650+

How the sentiment has turned around so quickly! We are now hearing many optimistic voices. A few are going ahead and calling it the return of a bull market. Even the not as optimistic do not expect the markets to fall to their previous lows. So what is this rally in reality? Is it a bear market rally or is it the return of a bull market? Does it stop here or does it have more legs to go up further? Are happy days back again or is it a false dawn?

Let us first look at the facts.
1.) We had last year, an unprecedented global economic recession, perhaps the worst in over 50 years. We witnessed the bursting of a 25 year long credit bubble. We witnessed economic growth in developed countries collapsing. The slowing down in developing countries feels like a recession even though growth is positive. We witnessed massive losses on asset prices. The patient had a massive heart attack and had to be wheeled into the ICU. The patient does not start sprinting the day he comes out of ICU. Economic data continues to be bad and is likely to stay bad for some time. World economic recovery would take time.
2.) Corporate earnings still face a lot of downward pressure. First, the era of cheap plentiful capital is past gone. Second, there is economic cyclicality to earnings. Third, earnings got to a higher base over the last few years. We are likely to see lukewarm corporate performance over the medium term.
3.) History does not repeat itself, but it rhymes. All previous bear markets took time to complete their course. Never have we seen a V shaped recovery out of a bear market. It is unlikely that 'this time it is different'. Remember, 'It is different' are the three most expensive words in investing. Bear markets end with revulsion as people get indifferent to stocks. They recover gradually and not like a 45% rally in 2 months. A new bull market begins with a different sector taking the lead, not by the most beaten down sectors rising the sharpest.

I think we are witnessing a bear market rally of suprising proportions. Make no mistake, a bear market rally was always on the cards, we never knew when that would happen. We never knew how large it would be. Last year, the fall was practically linear and quite spectacular. The bear market rally also has been spectacular. Like all bear market rallies, it has been sharp and swift, it has created a sense of optimism, it has given a lot of people a 'left-out' feeling and planted doubts in the minds of the bears.

The optimists say that we are moving out of the woods now. They say that markets forsee things about 6-9 months ahead of time, that they discount the future. That is not always true. Markets sometimes get things wrong. That is where crashes originate. The markets did get it right from 2003-2007. The markets got it wrong in Jan 2008, then again in October 2008. Do not fall prey to this 'wisdom' that markets always discount the future. Sometimes they are unable to do so.

Will this rally last? How long does it continue? One never knows. But lets look at a few facts again.
Early March this year, the consensus opinion was that markets would go down further. We could not fathom why anyone would buy stocks. People were talking about levels like 2100 or even 1800 on the Nifty and something like 7000 on the Sensex. That has not happened (at least yet) and the market headed higher instead.

Now people are talking about higher levels like 4000, 4100 and even 4300 if things go well. The general opinion is that the worst is behind us, the markets have put in place a bottom, that markets would not go below 3300 on the Nifty. Talking heads now opine how people have missed out the rally and how everyone is waiting with money to invest on a correction. Recall how in January 2008, with the Sensex well above 20000, everyone was saying the same thing.

When everyone thinks alike, no one is actually thinking. Its a monkey see - monkey do like behaviour. Markets have a remarkable way of proving consensus wrong. The consensus was wrong at 21000 Sensex level, the consensus was proven wrong again at the 8000 Sensex level. The stronger the consensus, the higher is the chance of it being wrong.

I perceive the consensus now to be much more on the positive side maybe not at peak levels, but getting there. No one is talking about a deep correction, say 25% or more. No one is talking about the possibility of corporate earnings not being worse than expected. Everyone is talking about a small correction, if any. Some are talking about higher levels ahead. There is a sense of being left out among investors, just like what it was back in October 2007. Back then every 6-7% correction was gobbled up intra-day as left out investors piled in. I sense something similar now.

Valuation wise, the Nifty is quoting at a PE of 17.23, with a P:BV of 2.99 and dividend yield of 1.53%. Hardly cheap; expensive in a bear market context. I thought that stocks were cheap by November 2008 end (Read my post http://shashankcurrentissues.blogspot.com/2008/12/it-is-time-to-buy-stocks.html). I do not think they are cheap anymore. Even the BSE-100 index has a PE of 18.5 now, up from 10.78 in October 2008!

Empirical evidence from history of the markets since 1991 suggests that whenever the markets have risen sharply by 30% or more in 2 months, they have usually been 15-20% lower three months from that point.

So can this rally go further? Sure it can; they say that risk-taking has returned. In my opinion, risk has returned. It is time to be cautious...