Bear market rally: Wait for it…

Everybody wants to know where the bottom is these days. Happily, analysts are beginning to say preconditions for a recovery are slowly coming into place, but they also say repairing the damage done by a bear market takes time and this current uptick is beginning to look a little long in the tooth.

Andy MacLean, director of private client investing and Clancy Ethans, senior vice-president and chief investment officer at Richardson Partners Financial Limited say the latest patterns of trading are consistent with markets that are tracing out a bottom.

Unemployment, growth measures, trade data and other indicators do point to more economic pain to come in the next few quarters, but other indicators — aggressive monetary policies, low interest rates, stimulative fiscal policies and surprisingly strong retail sales to name a few, are beginning to tell a different story.

“Confidence is difficult to restore as company and economic fundamentals continue to deteriorate,” MacLean and Ethans write. “Market bottoms typically encounter a good deal of disbelief in the early stages. We continue to believe that we are in the midst of this process.”

South of the border, Bank of America Merrill Lynch analysts say U.S. companies with stable earnings and lower foreign sales will likely outperform their counterparts going forward.

Daniel Tenengauzer, head of global currency at Banc of America Securities-Merrill Lynch, expects the U.S. dollar strength to continue for the near and medium terms, which he says bodes well for companies with pure domestic sales. Chief North American economist, David Rosenberg, adds the last of the profit crunch in the U.S. will likely be concentrated among companies with the highest foreign exposures: “Cyclical companies with a high proportion of foreign sales could be a good segment of the market to avoid,” say the report’s authors. To back this up, they point to estimate revisions that support Rosenberg’s view: “In March, 43 of the 50 companies with the highest foreign exposure suffered downgrades to estimates … whereas the revision landslide might be closer to the end for domestically exposed sectors that have already been marked down dramatically.”

Returning to Canada, MacLean and Ethans say stocks look cheap. Although Merrill Lynch analysts still observe that U.S. industry rotation is inching toward cyclical sectors, their model is still concentrated in defensive havens. “Until we see more signs of a rotation into the riskier end of the spectrum, we remain cautious.”

The Canadian observation comes with its own cautious advice but includes a slightly more optimistic take on movement: “The latest market rally has been led by a rotation away from the perceived safe sectors such as consumer staples, healthcare and utilities into the more growth-oriented cyclical, materials and technology stocks.”

What’s more, they say the market is trading at its lowest price-earnings ratio in several decades, reflecting a diminished outlook for corporate growth, normally only seen when the economy is on the verge of a deflationary spiral akin to the one suffered during the Great Depression. “Given the massive amounts of liquidity being added to the global financial system, we don’t expect deflation to take hold,” they say.

Moreover, there are signs of life beginning to show up in corporate earnings. Financial and consumer cyclical stocks are beginning to stabilize. Some even appear to be in a position to rebound sharply if earnings come in even slightly better than expected. “Just as a bull market is difficult to sustain once the leadership falters, the same situation presents itself in a bear market once the market leaders to the downside stop deteriorating,” say Ethans and MacLean.

In other sectors meanwhile, industrials, technology and materials are still declining, a situation that is expected to continue over the next quarter or two, while healthcare, consumer staples, utilities and telecom — the market’s “defensive sectors” — appear to be holding their own without deteriorating, despite tough economic conditions.

MacLean and Ethans recommend investors continue rebalancing their portfolios at this time, pointing out that an investor who had an asset allocation of 60% equities and 40% bonds last summer could have seen that allocation reverse to 40% equities and 60% bonds. “After re-examining their risk tolerance, investors should bring their asset allocation back into line with their long-term strategic goals.”

Second, they recommend putting cash back to work in equities if there are short-term, tactical reasons to do so, but they also suggest holding off on putting cash back into the market, recommending instead that investors choose to wait for a period of consolidation given that recent rallies are beginning to look somewhat extended, and use that market weakness to buy.

(04/20/09)