Dalton, Greiner, Hartman, Maher & Co., LLC

Is it over? The cyclical bear market in equities, that is. No one really knows, of course, and that includes us. However, the vast majority of investors don’t think it is. All day long investment professionals are appearing on CNBC and the like calling our attention to all that is wrong and what is likely to go wrong. We even heard one pundit the other day proclaim that the bear market will persist until the decline in home prices is over. And that could take another two years. Apparently it doesn’t matter to this person that there is virtually no evidence that the residential real estate price cycle has ever been an equity market catalyst in the past. Gloom and pessimism prevail.

Chart I

Equity Sentiment: Getting Closer To A Turning Point

Source: BCA Research

Strong consensus opinions are rarely right. And our guess is that the majority view this time around will be wrong once again. So, we’re giving you our punchline right up front. The odds favor that a trough in the cyclical bear market which began October 9th was reached in January. It probably won’t be straight up from here, but we think the path of least resistance is higher prices.

But that doesn’t suggest that it’s clear sailing for financial markets and the economy from here. Hardly. There’s plenty wrong. But everybody knows it, as the media is bombarding the public all day long with one negative story after another. Consequently, the degree of economic pessimism has reached an extreme:

Even our Fed Chairman acknowledges the significant financial and economic risks. In his recent testimony before Congress, he not only mentioned the “R word” but also spoke of its nontrivial probability. But that, perversely, is a good thing. Our monetary authorities are painfully aware of the systemic risks that pervade the global financial system and the contagion that is impacting developed economies, and more recently, the developing countries as well. Without a doubt, the Fed’s dominant concern is deflation. Not inflation. Not the stigma of the “moral hazard” tag from a real or perceived bailout. It will do anything at this juncture to avoid systemic failure and/or a severe contraction.

It has already done a lot. As we said it would in our February letter. At that time we said the whole arsenal will be available to policymakers. Rate cuts, special lending facilities, administrative actions, etc. And all of these tools have been employed over the past month or so, and we’re quite sure that many more policy initiatives will be enacted over the next several months as the challenges continue to pervade the system. Even Congress – surprise, surprise in an election year – is getting into the act.

There is no shortage of liquidity. Reflecting the Fed’s policy stimulus, money supply growth has accelerated sharply. The huge and growing surplus of savings generated by the developing economies (China, OPEC, Russia, Taiwan, Singapore, etc.) and Japan are continuously recycled back into global financial markets. These flows, as we’ve pointed out often, are largely responsible for driving long term sovereign interest rates to their currently extremely low levels. And reflecting the growing risk aversion and flight to safety, cash balances have surged.

How will we know if this unprecedented array of policy actions is working? Not easily. Unfortunately, a bell doesn’t go off announcing the end of the pain. Markets don’t work that way. What we do know is that equity markets always trough well before the nadir of economic activity. And their subsequent rise is often violent and extremely profitable for those who have the prescience and fortitude to swap liquidity for risk assets before the herd stampedes in.

Very few investors who have survived previous encounters with the loathsome bear have done so by committing all their dry powder without seeing some tangible evidence of a moderation in extreme risk aversion. We think we’ve begun to see some. Not a lot, but something.

First, credit spreads have contracted a bit over the past couple of weeks. TED, high yield, corporate and mortgage spreads are all off of their March highs:

LIBOR rates which had been extremely elevated have dropped sharply recently. The yield on the 2-year Treasury has begun to climb and is bumping 2% as we write. While rising yields are not normally a good thing for equity markets, this time it is. The 2-year yield had been pushed to extremely low levels as investors sold risk assets and ran for cover in these relatively secure securities. Consequently, a rise in the 2-year rate reflects an abatement of risk aversion. That’s a good thing.

It’s not clear whether the equity market bottoms before or after spreads peak. Stocks began a new bull market in 1990 some months before spreads peaked. On the other hand, spreads peaked prior to the outset of the most recent bull market which began for good in 2003. However, that observation is only true for the S&P 500 index which had been pounded by the implosion of the tech bubble. The vast majority of value and small cap equities had bottomed well before that.

What we don’t know for sure is if spreads have peaked. There’s a reasonable chance that they have as investors increasingly embrace the notion that policymakers will do anything to avoid the worst. Our guess is that we are currently witnessing the initial signs of dissipation in risk aversion. If so, the market has probably bottomed.

But we’re not stopping with spreads to search for signs of risk taking. Negative real interest rates have traditionally proved to have been a catalyst, ultimately, to improving economic activity and risk taking. The 300 basis point cut in the Fed Funds rate has pushed the official rate below the rate of inflation. One never knows if history repeats itself. However, the current bout of monetary easing is giving it every chance.

Rising stock market volatility is an indication of increasing concern among equity investors. Volatility had spiked sharply since last summer when the subprime issues surfaced. Although it’s too soon to conclude that equity market concerns are abating, volatility (as measured by the VIX Index) has declined a bit in recent weeks.

We’ve been a skeptic regarding the prevailing “de-coupling theory”. That view embraces a divergence of the deteriorating economic growth outlook for the developed countries and the still vibrant business outlook for China and most of the other developing countries. The de-coupling advocates point out that most developing economies are much healthier today (true) and that they are not totally dependent on exports and are actually enjoying strong growth in domestic demand (also true). So far, those advocates have been right and we’ve been wrong. The still vibrant economies in the developing world – particularly Asia – have been a source of continued strong export growth in the U.S., the last bastion of economic cheer.

Mortgage Refis have also revived. This is important. In recent years refis have provided cash for consumers to spend and invest. These “Mortgage Equity Withdrawals” have had a significant impact on consumer spending and economic growth. While, the magnitude of refis currently is far lower than the peak of a couple of years ago, it’s increasing and should begin boosting consumption modestly.

Maybe we’re grabbing for straws in a state of denial. But we don’t think so. Policy actions have been bold and nonstop. We expect more as policymakers will pull out all of the stops to avert systemic financial failure and a severe economic downturn. We think the markets are beginning to acquiesce to that view.

U.S. equities are a good value. While profits have held up reasonably well, we do expect them to decline over the next few quarters. However, we don’t expect a collapse in earnings. Meanwhile, the cyclical bear market has left many stocks selling at very reasonable – if not compelling valuations. No doubt many value investors are bottom fishing as we pontificate. Our guess is that positions taken in quality companies at these valuation levels will prove rewarding for patient investors willing to endure the possibility of near term pain.

We don’t think we have our heads totally in the sand. The risks are real and substantial. And maybe they will prove to be so overwhelming that risk aversion spikes once again. The Bank Credit Analyst estimates that there are still $100-200 billion of subprime losses to surface. Depending on the depth of the economic slowdown, they expect another $135-225 billion in losses from leveraged loans and consumer and corporate debt.

A recent study written for a U.S. Monetary Forum Conference Draft attempts to quantify the drag on the U.S. economy from the potpourri of credit losses. They estimate that total mortgage credit losses will approach $400 billion, and about half of these hits will be absorbed by U.S. leveraged institutions. The authors assume that the balance sheet leverage for these financial institutions will be halved which will result in a $900 billion decline in business and consumer lending. A contraction of this magnitude would cut GDP growth by 1-1 ½%. And that’s just the first order effect.

In our February letter we cited our concerns over the rise in risk aversion and the subsequent deleveraging of balance sheets by consumers, businessmen and financial institutions. This clearly is happening, as the various economic entities experience eroding asset values and the decreasing availability of plentiful and affordable capital.

Everyone knows that private indebtedness has been growing far more rapidly than GDP. Moreover, borrowing has been growing well above its secular trend over the past century.

If extreme risk aversion among both lenders and borrowers persists, it’s quite possible that the growth rate in lending reverts to its mean. If so, the adverse economic possibilities cited above will become reality.

We don’t expect such a dire outcome. Increasingly, the stock market is reacting quite well to the steady barrage of negative economic news. Investors seem to be accepting the fact that the Fed and other policymakers – both here and abroad – will pull out all of the stops to escape Armageddon. Our bet is on those policymakers.