The strong rally in global equity markets continues to confuse and surprise most market participants. Most hedge funds seem to have been caught underinvested, and the long-only folks by and large are stuck in the wrong sectors, being heavily overweight defensives.
A continuing stream of better than expected economic data is forcing investors to reposition portfolios, and this act of repositioning is driving up markets to levels that no longer seem attractive from a valuation perspective.
Having gone through a very tough 12 months, investors are naturally worried about not taking further losses, and are thus loath to chase this rally. Investors are damned if they do and damned if they don't.
If they buy now and the markets fall, they are bound to get asked questions on chasing the market, and if they do not participate they will be asked on underperformance. Invariably it is now when fund inflows will also start.
It is rare to have so many investors, all hoping for a market pullback, and unhappy as the market keeps rising. There is a very strong left-out feeling globally and across investors.
Because of the above dynamic, the rally is likely to last longer than people think, and unlikely to correct severely, unless we get a new unanticipated external shock.
As the folks at GaveKal point out, the number of months when the MSCI world index was up more than 10 per cent (April 09 was plus 11.6 per cent) are few and a rare enough occurrence to pay attention.
It has happened only on five other occasions since the index was launched in 1969, and on each such occasion stocks were higher in 12 months.
Thus buying post such a strong move has not been historically a recipe to lose money. They have also gone and done a similar study of market moves around the great depression period.
The point they make is that while one saw strong single-month performance, which then faded away and were false starts in this period, in these false starts we never saw two consecutive strong months. The first time we had two straight strong months of market performance (July/August 1932), it marked the bottom for the Dow.
The rally thereafter was huge with a subsequent retest of the lows, and another large upwards move, but the bottom held. They point out that we have just seen two straight strong months in the MSCI World index (plus 7.54 per cent in March, plus 11.5 per cent in April).Will the parallels hold?
The bulls make the point that we have now removed the financial system collapse scenario from the set of possible outcomes, and with the removal of this tail risk, markets should go back to a more pre-Lehman type of trading zone. If most credit market spreads have reverted back to a pre-Lehman type of world, why can't equities?
The S&P was at 1,200 prior to Lehman's collapse. Prior to the Lehman collapse the world was worried about an economic recession and economic issues, not systemic collapse, we are possibly back to that type of a world. Equities in a way are effectively lagging the normalisation of other asset classes.
The bulls also point to the turn in economic indicators. The ISM survey, Michigan Consumer confidence index, Conference Board's coincident-to-lagging indicator -- all these measures seem to have bottomed.
The economy always bottoms within six months of these indicators troughing. Given the way the data has been breaking over the past few weeks, it does seem that we are past the midway mark in the recession at least in the US, and equity markets normally bottom around 60 per cent of the way through.
Thus if one takes the economic indicators at face value, you can make a case for an economic and market bottoming.
The bears will make the normal arguments about the economy being weaker for longer than the current consensus assumes. Most bears expect no growth in the OECD economies even in 2010.
There is also concern around corporate earnings, as they are bound to be weak in an environment of very low nominal GDP, and are coming off a very high profit share of GDP. Valuations are no longer cheap and, in any case, never got to levels that typically mark significant bear market bottoms.
Many also wonder where the $500 billion of additional capital the IMF projects as being required will come from. There also exists the possibility of further macro-shocks linked to the dollar, sovereign defaults and some type of stress in the eurozone.
Be that as it may the reality remains that there is still too much scepticism on this rally. The pain trade remains the markets rising further, and we still have too much money sitting on the sidelines.
I still feel that we are in a structural bear market, but within that type of construct we can have sharp and sustained bear rallies and this is what is currently going on.
Investors seem to be desperately hoping for a correction, which indicates that any market fall will be brief and shallow. The markets will not stop rising till everyone gets sucked in, and people no longer feel nervous calling this a new bull market.
The problem for the bears is that at least until September, the bulls can keep on with the second derivative of data-improving type of theory with almost total impunity. The economic data is likely to keep improving slowly on the margin as restocking of inventories begins and confidence creeps back among corporates.
Frankly until end-September the bears will not be able to show that growth is stalling or that 2010 will not pick up either and that earnings will remain weak. The onus is now on the bears to show that growth will not pick up in end-2009 and accelerate further in 2010.
With the stress test results due this week, and given the muted market reaction to the leaks till date, there seem to be no other macro-hurdles for the market to cross in the near term.
India is currently part of this global rally, and for us to break out on either side we will have to wait for the elections. If we get a decent election outcome, the markets could really catch fire.