Long-Term Key: +52

 

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Inside this week's update...

 

***** Is the rally near its end?

***** What would it take to repeat the 1930’s?

***** Don't get excited about mediocre news.

***** Stay safe.

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The stock market has been valiantly resisting downward pressure over the past couple of weeks. A swine flu pandemic could certainly hurt the economy, although the initial reports suggest that this strain is fairly mild. Nonetheless, the market is shrugging it off.

 

Frankly, we're a bit surprised the market has refused to decline in the face of falling economic activity. And we're not alone. In light of the fact that the leaders of the recent rally have been the low-priced stocks, one of the big brokerage firms conducted a study recently. They took 500 stocks on the New York Stock Exchange priced under $5 and calculated their performance since the early March low. They found that, on average, stocks in this group gained 120%! That extraordinary gain suggests that either the market has become extremely frothy or it is discounting massive inflation/reflation and a rapid return to economic growth.

 

So we turned to the history books to look for a comparable situation, and found it doesn't exist. The only cases where comparable rallies in small caps took place were ones where small caps had previously fallen further than the overall market. However, in last year's sell-off, small caps fell in step with their larger cousins. Nonetheless, here's the most helpful analogy we could find...

 

WHAT PEOPLE FORGET ABOUT THE GREAT DEPRESSION

 

The market rebound in the summer of 1932, led by small cap stocks, launched a bull market that lasted until 1937. Like today, the small caps rose by well over 100% in the early stages of the rally.

 

Yet 1932 differs from today in important ways. In 1932, small caps had been knocked down over 90% in the preceding bear market, far underperforming the big caps. What's more, the rally in small caps seemed to anticipate the end of the depression in 1933. (Although most people forget this fact, the recession officially ended before Roosevelt took office in April 1933.) 

 

Certainly, we are tempted to believe that today's rally is a replay of 1932. Most investors would be pretty happy if it was. Yet we still have a few unanswered questions.

 

First among them is the question of economic growth. When the recession ended in 1933, the economy took off like a rocket. Growth reached 5-6% annually. (The other thing people forget is that the 1930’s was a period of rapid growth.) 

 

One reason the Depression got its name was because of employment that never came close to its previous high. Other than that, a close look at the data from news articles and the NBER reveals that the economic statistics began moving upward as early as 1932. Gross income, for instance, began rising in 1932. Capital construction began a marked uptrend. Even price changes improved. Overall income in the economy also bottomed in 1932.

 

These facts imply that, if today's rally is the real thing, the economic data need to be much stronger than we have seen so far. Today, people are getting excited by data that is merely less negative than before or less negative than expected. Positive data has yet to arrive.

 

As we pointed out in an earlier update, markets don't discount the end of recessions but the start of strong, sustained economic growth. As the 1930’s demonstrated, the economy mustn’t be perfect, but the growth should return before the market rally can be sustained. So, for this rally to have legs, investors would need to see positive economic data that indicates the immanent arrival of full-fledged growth. They would also need to believe that a robust economic recovery will emerge by 2010. We're unconvinced.

 

Sure, we could see the market rise a little more. It's already risen more than we expected. But until we see clear signs of improvement, we cannot sound the all clear.

 

What's more, we remain disturbed by recent trading activity and the tendency of the market to be fragmented. Leadership has come mainly from the financial stocks and cash-rich technology shares. Overall, the market seems to be discounting not growth but less-than-worst-case results for the banks. Investors are moving into techs with enough cash to survive. This is not the making of a major global boom. So here's what to do...

 

STAY PATIENT

 

Keep your powder dry for now (i.e. have some cash reserved for when the real bull market begins). Don't chase this rally, because it might not last long. 

 

The government's enormous stimulus campaign has no parallel. Yet we're still waiting for some sign that the flood of liquidity is finding its way into corporate and consumer pockets. Despite the monumental increase in the monetary base, M2 stayed flat over the past few months – suggesting that bank lending has actually declined. Yet without higher bank lending, economic growth has no chance of returning to its former robust level.

 

We wish the situation were better. We wish we could announce the return of strong growth and a bull market, and tell you to start buying shares with both hands, but the evidence to support that call is nonexistent.

 

Any growth we do see going forward will probably be inflationary growth. Therefore, we will stick with our investments in precious metals and commodities. Few other industries (with the possible exception of defense) reflect any hint of long-term growth.

 

Until next week,

 

Stephen Leeb, Ph.D.

Editor

The Complete Investor