With the US stock market on an upward curve, Proinsias O'Mahonylooks at whether arguments for long-term optimism are well-founded

AFTER ENDURING its worst start to a year since 1900, the US stock market reminded investors over the last fortnight that indices can go up as well as down, enjoying a rapid 15 per cent gain. Does the rally have legs? Have the markets bottomed? Or is this yet another sucker’s rally? Let’s take a look at the arguments advanced by the bulls.

Miserable market sentiment is bullish for equities

Immediately prior to last week’s rally, the weekly poll commissioned by the American Association of Individual Investors (AAII) revealed that more than 70 per cent of retail investors were bearish in their outlook; just 19 per cent were bullish. That’s the most pessimistic reading over the lifetime of the poll and indicates that dumb money has capitulated. The recent spate of articles pronouncing the death of “buy and hold” as an investment strategy is additionally exciting to contrarian-minded investors.

Verdict:Studies show that the AAII's "dumb money" reputation is well-deserved. Every significant rally over the last 18 months has been preceded by a jump in bearishness. While AAII readings are ordinarily consulted by those with an intermediate rather than a long-term horizon, the fact that the latest reading is so pessimistic increases the odds of a long-term bottom.

Note that the survey only dates back to 1987, however, so be wary of the “most pessimistic in history” argument.

Markets remain oversold

Before the recent upturn, just 5 per cent of stocks were trading above their 50-day moving averages. Despite the bounce, that percentage remains low (approximately 20 per cent), suggesting markets have further room to run. Some $3.8 trillion is on the sidelines in money market funds, up from $2.4 trillion two years ago, providing potential fuel for any such rally.

Similarly, the SP 500 began March almost as far below its 200-day moving average as it was last November, when it fell 39 per cent below the aforementioned average. Such a reading had not been seen since the early 1930s and a two-month, 27 per cent bounce ensued. At the very least, expect something similar this time.

Verdict:Picture a rubber band stretched to near-breaking point and the resulting snap-back effect. Dramatically oversold markets are not obliged to rally but more often than not, they do.

Bearish magazine covers

Sensationalist magazine covers often indicate near-term turning points, according to money manager Paul Montgomery, creator of the so-called Magazine Cover Indicator. Montgomery is encouraged by the recent Time cover, “Holding on for Dear Life”, which showed a pair of hands desperately grasping onto a near-shredded rope.

Verdict:Don't laugh – studies confirm Montgomery's thesis. Still, think of this as a supplementary rather than a standalone indicator.

Optimism among regulators and banking CEOs

Federal Reserve chief Ben Bernanke said this week that the recession will come to an end “probably this year”. Chief executives at Citigroup and Bank of America, among others, said last week that 2009 has been profitable so far and that they are confident going forward. Nationalisation fears are overdone, they say.

Verdict:Why trust Ben Bernanke's predictions? In 2005, he denied the existence of a housing bubble. In 2007, he said that damage would be confined to the subprime sector. That goes double for bank chiefs – this time last year, one after another lined up to assure investors that "the worst is over us".

Best to think of their recent utterances as political posturing in the face of increased nationalisation calls.

Changes to mark-to-market accounting

Changes to the system are expected in the coming weeks. That will greatly benefit banks as mark-to-market forces them to mark their assets to their current market value, even if they have no intention of selling them. This leads to massive writedowns and capital losses and is the “principal reason why our financial system is in a meltdown”, as publisher Steve Forbes said.

Verdict:Blaming mark-to-market for the financial crisis is, as New York Times commentator Floyd Norris said, like blaming the weather service for Hurricane Katrina. Furthermore, changing the rules could lead to so-called mark-to-myth: fictional balance sheets would further damage investor confidence in the sector.

Kenneth Rogoff, the much-respected Harvard professor and former IMF chief economist, has criticised the Obama administration for taking a “wishing it away” approach to the crisis, warning of a Japanese-type lost decade unless the real problems in the banking system are faced up to.

Bears are turning bullish

A number of long-term bears are now bullish. Marc “Dr Doom” Faber recently predicted strong equity returns over the next decade. Short-seller Doug Kass said this month that the market has bottomed. Steve Leuthold, who runs a high-profile short fund that returned 74 per cent last year, said that “every investor ought to be considering putting money into equities” while Bill Fleckenstein, another bear who predicted financial Armageddon, is “starting to build a shopping list” of stocks.

Jeremy Grantham, the so-called perma-bear who predicted both the dotcom crash and the financial crisis, is increasingly bullish and sees annual returns of between 10-13 per cent after inflation over the next seven years.

Verdict:Not everyone has changed their mind – Nouriel Roubini sees the latest bounce as another "sucker's rally" while Merrill Lynch's David Rosenberg estimates that the market will not bottom for some months yet – but the list continues to grow.

Reinstating short-selling restrictions

Up to 2007, the so-called uptick rule meant that short-selling could only be executed in a rising market. The repeal of that rule was followed by huge market declines and massive volatility. There is increased chatter that that the rule will be reinstated in the coming weeks. That’s bullish for stocks and the financial system.

Verdict:Bunk. The rule was abolished after studies had shown it to be irrelevant. Besides, short sellers didn't cause the financial crisis – the financial crisis caused the short sellers.

Stocks are cheap

After inflation, stocks are no dearer than they were in 1968 – the “sale of the century” to quote Obama economic adviser Larry Summers. Peter Lynch, one of the most successful fund managers of the last century, said that bargains abound, making one “feel like a mosquito in a nudist colony”.

The stock market is currently valued at less than 60 per cent of US GDP, compared to 153 per cent in 2000. Cyclically adjusted price-earnings multiples suggest stocks are significantly under-valued by historical standards and are at levels typically seen at the bottom of most bear markets.

Verdict:Cheap? Yes. Poised for out-performance over the next decade? Yes. Sale of the century? No. Stocks ended up much cheaper in the 1930s and in the early 1980s. That's why Prof Robert Shiller advises investors to wait for lower prices, even though he believes stocks are undervalued.

Similarly, Jeremy Grantham warns that history suggests stocks might go much lower.

Conclusion

Technical and sentiment analysis suggests an intermediate-term bottom is in. Arguments regarding banking prospects have less merit. History indicates that a long-term bottom has not yet been seen. However, even if that’s the case, there are obvious grounds for optimism. David Rosenberg, long one of the most pessimistic commentators, said that “90 per cent of the bear market is behind us”.

Similarly, Jeremy Grantham cautions that while stocks might go much lower, they are poised to significantly out-perform over the next decade. To reconcile the two, he recommends scaling into investments.

“Life is simple,” he said in his latest letter to shareholders. “If you invest too much too soon you will regret it.” However, “if you invest too little after talking about handsome potential returns and the market rallies, you deserve to be shot.”