It’s Good to Be a Pig

The recent drop in the Shanghai market has gotten everyone scared. Sharp downward movements tend to focus the mind, just as a good hanging in the Old West used to do. Suddenly the conventional wisdom is that the powerful rally in stock markets around the world is unjustified and has gone too far, too fast. Stocks are no longer cheap, the bears say, and the global financial system remains on its sickbed. Most economists and investors believe that while the world economy may rebound in the next few months, it's a bounce engineered by stimulus programs like Cash for Clunkers, and, as the steroids wear off, there will be another dip in 2010.

I think the bears are wrong on both counts. There's no question that stock markets have rallied ferociously since March. There have been surges of 40 to 50 percent in the major markets in the U.S., Europe, and Japan. In emerging markets, where stocks fell furthest, some of the recoveries have been even bigger. These are huge swings, and those with a jaundiced eye have pointed out that in the 22 bear markets America has suffered since 1900, the average gain off the bottom in the first five months has been 24 percent. Some of the gains this time have been twice that, and thus dangerously -excessive—or so the thinking goes.

Rallies of this magnitude are not to be scoffed at, particularly if you missed predicting them, as many of the bears did. But I would argue that it's not the percentage change from the lows that matters; it's the amount of the lost altitude recovered. In judging how high a tennis ball dropped from a height should bounce, you would expect a ball dropped from 20 feet up to rebound significantly higher than the same ball dropped from 10 feet. In those same 22 bear markets cited above, the Dow Jones industrial average in the first big rally recovered 47 percent of the decline. This time the Dow Jones has made back 38 percent of its fall.

Here's further evidence that there may be more life in this rally: Morgan Stanley has done an analysis of 19 major secular bear markets (i.e., those with a decline of more than 40 percent) in stocks in the U.S., Europe, and Japan, and in gold. The average fall was 57 percent, which is about what both the U.S. and Europe were down from the October 2007 highs to the March 2009 lows. The bank found that secular bear markets are always followed by a powerful rebound, that the smallest rally before stalling was 41 percent, and that the shortest rally was eight months. The average was 71 percent over 17 months. Europe this time is now up 42 percent in a little over five months.

All this suggests that the rally is still below average, in terms of both magnitude and duration. In fact, so far this year the credit markets have had even bigger recoveries than the equity markets. Around the world, the credit markets (particularly junk bonds) have recovered to pre-Lehman-bankruptcy levels, which indicates that either the S&P 500 should now be around 1250 instead of 950 or that the credit markets are nuts. In addition, valuations in Europe and Japan on normalized earnings are downright cheap, and in the U.S. they are near their long-term medians. Free cash-flow yields are at record levels. The bottom line is that history and cold, hard analysis of the fundamentals suggest that this rally will last longer and go further.

Does history matter? You bet it does. Markets and traders—whether they think in English, German, or Chinese—are all about fear, greed, and emotion. In the long run, the fundamentals of economic activity and geopolitical behavior are what really counts. But in the short term, psychology matters more, and human beings panicked in the first quarter of 2009 in the same way as they did in 1910 and 1930. History is not an infallible guide to the course of financial markets, but in my view it's a headlight.

Does this mean we are in for a new bull market? Not necessarily. Secular bear markets are caused by severe structural aberrations and take time to heal. In America, such markets in 1932, 1938, and 1974 were followed by peaks and valleys lasting years. Japan's markets have had broad trading ranges for nearly 20 years since that country's bubble burst in 1990; the old highs are still far away. In this light, the U.S. and Europe have been in a bear market since 2000.

I'm afraid the odds are that over the next five years, the mature G7 economies will grow more slowly than they have in the recent past, and financial-market returns will be uninspiring. That said, I would also argue that the rally that began in March has further to go, and that it's too soon to run for the hills. It takes courage to hold fast and be a pig, as they say on Wall Street—my money is where my mouth is.

Biggs is managing partner of Traxis Partners Hedge Fund in New York.

© 2009