Bullish Days Ahead But Bear Is Lying In Wait For The Kill

We are into the fifth week of upswing in the stock market. While stock valuations remain attractive for value investors, the market is overbought and a major correction is overdue.

That is not to say that this bear rally is all fluff. “Green shoots” are sprouting and there are positive long term implications for the general economy. From Ben Bernanke’s purchase of Treasuries and toxic mortgage based securities to the recently concluded G20 summit, where a $1.1 trillion stimulus for the International Monetary Fund (IMF) and other international institutions was announced, a bullish vibe has developed.

US retailers are also wearing a smile with improved sales, in a sign that shoppers may be regaining confidence to open their wallets after more than a year of recession. Of those which reported March sales, more than half topped Wall Street estimates, and a handful even raised their quarterly earnings outlook.

New jobless claims also fell more than expected by three percent last week. Nevertheless, the figure which is still above 650,000 and remains at a 26-year high is not pretty and is not enough to fuel the rally by itself.

What gave the rally extra legs was the announcement by Wells Fargo that it expected a “record” net income of 3 billion dollars for the first quarter. Following earlier reports by Bank of America, Citigroup, JP Morgan and Goldman Sachs that January and February were profitable months, investors were already upbeat on the financial sector’s earning reports.

Still, Wells Fargo took the cake by topping market expectations with a 50% surge in earnings as compared to a year ago. The main contributor was its newly acquired bank, Wachovia while the easing of mark-to-market regulations also played a part in lowering provisions for bad loans. The new rules allow banks to value their assets, instead of marking them at the price they will get in an open market currently.

There is a strong case that mark-to-market accounting undervalues assets and unreasonably hurts the balance sheets of financial institutions, especially when the market is frozen. Billions of dollars in assets have been written down and resulted in the credit crunch and worsening recession.

The banks have been lobbying left, right and center with a seductive argument that lending is curtailed because they cannot meet regulatory capital requirements. But they will have enough capital if they ignore the market and value assets at what they think they’re really worth. Congress swooned at their theory and have been pressuring the FASB to change or be changed.

FASB caved in, and financial institutions are now free to apply the new rules to their financial statements for the quarter that ended on March 31st. Knowing that Mr Market can be susceptible to mood swings and manipulations, having the “discerning” bankers exercise judgment in valuing their assets can reduce the irrationality. However, I am concerned that a practical idea can be taken to extreme in the hands of greedy and irresponsible people.

The banks could hide reality from investors under the pretext of distressed market and take matters into their own hands. Investors are no closer to knowing how much an asset is really worth. The banks can justify themselves with complex models by employing the best mathematicians and using the most advanced super-computers but we know how ineffective modelling can be when assumptions are flawed and the unexpected happen.

Will the banks assessing their own assets make them less toxic? Are the new valuation of assets based on what the banks could get selling it today or at a later time when the market comes up? Now, long run can be a misleading guide to current affairs by glossing over short term problems. Everything will even out in the long term, as any statistician will attest and the best thing is it doesn’t matter because “in the long run, we are all dead.”

There will certainly be more Enrons in the making which can only be countered by the implementation of effective disclosures. If the banks are not accountable and transparent, investors are taking huge risks by placing their faith in the balance sheets.

So far, no one can declare confidently that bear rally is over. It has the potential to last another couple of weeks and create higher lows before it hands back its gains. To be sure, bear market rallies that propel stocks 40% higher from their lows are a common occurrence.

But investors should note that fundamentals will not be rosy in the short term. In the case of Japan, exports are down 49% from a year back. Exports to the US, Japan’s largest trading partner, collapsed by 58.4% which is especially tough for small businesses. Industrial production was down 9.4% in February and the economy contracted 12.1% in the first three months of the year. Amid the gloom, companies are forced to cut jobs and salaries.

Japan is not alone and other export economies, including Singapore, are dealing with declining order books and massive job losses. The United States is the main source of demand for the world economy. Until American consumers are in a mood to buy goods or services, global trade and stock markets are not expected to boom.

Nevertheless, it is encouraging to note that Japan has unleashed another fiscal stimulus of 10 trillion yen to fight the economy’s deflation. This amounts to 4% of the GDP of the country being spent on stimulus. This is a further addition to the 12 trillion yen in spending planned under a previously announced stimulus package.

There is also a ton of bricks hanging precariously above our heads if the International Monetary Fund’s forecast (which will be announced on April 21) that toxic debts incurred by banks and insurance companies have could soar to $4 trillion materialize.

This assessment will be hugely anticipated because of the sheer size and is nearly double the worst estimate we’ve heard so far. It is an indication of how deep the global economy is mired in debt. The latest figure will include $900 billion for toxic assets that originated in Europe and Asia.

The Federal Reserve has also put the muzzle on banks on the ‘stress test’ results which are to be revealed after the first-quarter earnings season. In normal circumstances, investors should take the stress tests in their stride and should not cause disruption to the stocks… unless there are worms in the can or more bailouts in the pipeline.

There are still much uncertainties around. The bottom of a bear market is usually marked by extreme hardships in the streets. And in the event of a sustained bull run, investors must experience a period of relative calm for accumulation, where confidence can gradually be restored and convictions allowed to steadily build.

That has yet to occur. Meanwhile, enjoy the continuing rally which will be good while it last. Just don’t get stuck with delusional optimism and invest with abandon.

Some people are not yet used to the idea of using an internet bank for their financial accounts but if you’re one of these people you should reconsider. Internet banks usually offer better CD rates than your bank around the corner because their expenses are very low. If you don’t have an internet bank account your should consider getting one.

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Filed under Banking, Economy, Stocks

3 Responses to Bullish Days Ahead But Bear Is Lying In Wait For The Kill

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  3. This assessment will be hugely anticipated because of the sheer size and is nearly double the worst estimate we’ve heard so far. It is an indication of how deep the global economy is mired in debt. The latest figure will include $900 billion for toxic assets that originated in Europe and Asia.

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