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THE CURRENT MARKET ARGUMENT PITS the charts against the cheap, the increasingly worried tape readers who see an enduring downtrend emerging versus the spread-sheet studiers who spy increasing value with every percent decline in the Dow, and contend that stocks are over-anticipating a recession relapse.
The charts, plainly, are delivering cause for concern, a fairly clear downward trend in the major indexes since the April high, and heavier selling on down days than there has been buying on rallies.
The talk of technical risk has been spiced with phrases that seem out of youth adventure fiction, such as the purported "death cross," an impending moment when the Standard & Poor's 500's 50-day moving average crosses down below its 200-day average–a juncture with a somewhat more ambiguous predictive record than its lethal name suggests.
Some, but not nearly all, technicians are either stating that a new bear market is under way or are waiting for a few unmet conditions to kick in before making that call.
One approach to market timing just raised the caution flag. Some advisors watch when the S&P 500 crosses above (a Buy signal) or below (a Sell) its 12-month average at month's end. Last week's June close fell below the average for the first time since July 2009. This approach kept adherents in cash before most of the 2000-2002 and 2007-2009 routs, and they managed to participate in most rallies, but Sell signals failed to predict a further decline most of the time.
Not every study of internal market dynamics is screaming at investors to flee, and it is not yet fully obvious that the markets are sending a reliable foreboding message about the end of a U.S. economic recovery. Even as the S&P 500 made new lows last week, falling another 5%, to 1,022.58, for a loss of 16% from the April high, the options market's volatility index stayed at levels well below the June highs, a modest positive. Corporate-credit spreads, the excess in their yields to those of Treasuries, would be expected to gap out to much wider levels ahead of a recession, and they have not.
The cheapness of stocks being celebrated by some market fundamentalists can be measured in multiple ways beyond the simple price/earnings ratio.
Citigroup strategists point out that their gauge of stock-bond valuation shows equities at a deep and rare undervaluation versus high-grade bonds. Nomura quantitative strategist Joe Mezrich calculated last week that at present levels, stocks were implicitly pricing in five-year annual earnings growth slightly below zero, going from somewhat overoptimistic expectations at the start of the year to quite pessimistic ones now.
Credit Suisse strategist Doug Cliggott, who deftly foresaw the ongoing growth scare and market setback in the spring, puts fair value for the S&P between 1050 and 1150 for year end 2010, and says below that band he'd look to put cash into the market, albeit in defensive stocks.
Quite clearly, bear markets make cheap-seeming stocks seem progressively cheaper. And with enough daunting big-picture concerns chewing up the cable-news airtime, it might not take much more than continuing popular doubt about economic growth or global financial stability to bring on one of those intense liquidation phases we all recall.
One way to explain the current rush to predict a punishing bear market since stocks fell more than 10% and the conflation of that with a surefire double-dip signal is to note the scarcity of deep corrections and relatively undamaging cyclical bear markets in recent decades.
Doug Ramsey, research director at Leuthold Group, made this observation in the firm's client report for June. There have been only two of what he describes as severe corrections of between 12% and 18% between March 1980 and March 2010. In the same period there were six washout bear markets averaging a 34.3% loss. From the 1930s to 1980, those corrections outnumbered true bear markets.
So the present generation has little muscle memory when it comes to declines that are painful and scary–often not associated with a recession–and that lie somewhere between a painless dip and a crushing collapse.
Ramsey is sticking for now with the stance that this remains a deep correction, not a fresh bear market. In a chat Friday he said that "it sure seems like we are so close to 1000 [on the S&P] that maybe we've got to go down below there and test" lower levels. That could scrape the index against the trite definition of a bear market as a drop of 20% or more.
Ramsey, though, figures that the past few years have been so dramatically volatile—a 57% waterfall in 18 months followed by an 80% rally in 13—that it's necessary to scale the next retrenchment according to the size of the rise. He cites, as precedent, what he calls several past "noneconomic" bear markets—those without far-reaching economic implications—in the mid-'30s, 1962, mid-'70s and 1987.
E-mail: michael.santoli@barrons.com
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