The Odds on Market Recovery

This year’s market action has been a perfect advertisement for the Rip van Winkle school of investing: trade little, go to sleep for a year or two, and come back to find that nothing much has changed (FT Column, published May 11th 2009). At the time of writing, both the S&P 500 and the FTSE 100 index are up around 1% for the year. Yet what a ride it has been for those condemned to follow it day to day since the beginning of the year – from falling knife to what may be a runaway bull market in the space of little over two months.

If the March lows prove to be the lows for this phase of the equity market, as now seems very possible, it will be the third time in a decade for UK investors that the middle of March has proved a decisive turning point in the market. That should provide plenty of ammunition for researchers anxious to uncover a new statistical anomaly. “Change tack in March – and don’t turn back”, or something to that effect.

We don’t know for certain that we won’t see new lows again this year, of course. In his latest quarterly letter, Jeremy Grantham of GMO, one of the few asset allocators who sensibly acknowledges that market calls really are probabilities at best, never certainties, puts the odds of the market finding a new low this year or next at slightly better than evens. In practice, so he told me last week, these odds have been improving by the day, the longer the market recovery continues.

If the US economy picks up later this year, as he thinks it probably will, then the odds on the markets avoiding a new low will rise even further. It is only if the economic reality turns out to be disappointing later this year that the odds will go the other way. He thinks that this year’s market recovery could easily take the S&P 500 as high as 1100 before the recovery is done, although fair value in his view is only around 900. That looks possible to me too.

On the other hand, if that outcome does happen, it will certainly not stop us entering a new period of what Mr Grantham calls “long, drawn out disappointment” in the economy and the stock markets of the developed world. He is surely right that the fallout from the financial crisis cannot be wished away so easily. His view is that this market revival, which he has backed with a big chunk of his clients’ money in two big calls over the past six months, represents a “last hurrah” for the bulls.

If we are now past the markets’ turning point, it looks as if Governments the world over will have not just their massive stimulative efforts to thank for the revival in market sentiment, but also, paradoxically, the hedge fund community that they so love to malign. The smart bets that Odey Asset Management and Lansdowne Partners, among others, placed on UK banking stocks a couple of months back have been the starting gun that has fired bank shares on their current upwards trajectory.

On April 28th the newly bullish Mr Odey, in his quarterly call to investors, declared that shares in Barclays, his biggest call, then at £2, could go as high as £4, or five times what he paid when he made his first move into the banks. Ten days later the shares were already halfway to his target figure, as those who were short or still gloomy about the banks scrambled to cover their positions and catch the big move – the point being that if you have decided that the banks aren’t going to go bust, then it is no longer crazy to start valuing them on their earnings capacity and potentially fat margins. That assumption could still be tested on the GMO worst case scenario.

The last month’s market activity has been a textbook example of how bear markets, when they end, have an enormous capacity to catch out the unprepared and mentally rigid. It is unlikely that whatever they may say in public, Mr Bernanke or Mr Brown will on this occasion begrudge the handful of hedge funds who have profited from the banking sector revival their outsize gains. Although at least half the overgrown hedge fund sector will in due course disappear, the experienced hard core that will survive can at least now point to a genuine example of a periodic useful social function.

The biggest surprise of the market rally so far is not that it has happened, but that it has been that it has been led so aggressively by riskier assets, including emerging markets and midcap stocks. This appears to be proof, if proof were needed, that Warren Buffett was right when he said earlier this year that the world has moved from underpricing to overpricing risk. The fact that none of the four professional investors he selected a couple of years ago as potential successors for his CIO role at Berkshire Hathaway managed to beat the S&P 500 last year also tells its own story – which is never write off a great investor, especially one who still owns such a big chunk of his own investment vehicle.

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