Is this a bear market rally or a turning point?

May 17th, 2009

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The global stock market has been rallying for the past couple of months already. There have been talks of “green shoots” of economic recovery. There are hopes that China’s stimulus spending will bring out renewed demand for Australian commodities. Already, there are reports of record Chinese demand for commodities (see China on buying spree).

We heard of many retail investors piling into the stock market, not wanting to miss out in the turning point. Since the stock market tends to be a leading indicator of future economic activity, many are seduced by the idea that this rally is predicting a turning point in the global economy. Unfortunately, as with many cliché ideas, this is only half-true. This is an example of a mental pitfall called lazy induction (see Mental pitfall: Lazy Induction).

To be more precise, the stock market anticipates but not predicts turning points. What this means is that economic recoveries are followed from recoveries in the stock market, but a stock market rally does not necessarily indicate an economic recovery. A very good example will be the number of bear market rallies in the chart of the Dow Jones from 1929 at Bear market rally on the works?.

Now, let’s take a read at what Marc Faber says about this rally in his latest market commentrary:

The economic news in the world is hardly getting any better, but the rate of economic contraction has slowed down somewhat as the  governments? stimulus packages begin to have some impact and as some replacement demand is starting to support consumption. However, to talk  already now about a sustainable economic recovery seems premature because whereas some sectors (autos) and regions may be stabilizing, others are still in a steep decline.

The global economy are declining, but the speed of decline is not as fast as the second half of 2008. Therefore, this stock market rally is anticipating that this reduction in speed is a turning point.

The next question to ask is this: will the stock market be lower or higher in 2010? Even Marc Faber admitted not knowing the answer to this question. Indeed, it is certainly possible to see another bout of breathtaking crash that can rival the panic of 2008. There can be many possible triggers for that, including:

  1. Collapse of a major European bank. Many big European banks lent so much money to Eastern Europe that their asset books are even bigger in size than the GDP of some European nations! Meanwhile, many Eastern European economies are in serious trouble, which means there will be many gigantic bad debts floating around. The European Union is an economic union but not a political union. Therefore, the European Central Bank (ECB) does not have the same level of authority and political support as the US Federal Reserve. Individual nations using the Euro as their currency cannot simply print money to bail out their financial system because they have surrendered their economic sovereignty to an intra-national authority. To do that, there can be a situation whereby taxpayers of say, Germany, are asked to bail out the taxpayers of say, Spain. Politically, this is too much to ask. Therefore, if a banking crisis is to hit Europe, the political deadlock can result in another panic in financial markets.
  2. Swine flu
  3. Collapse of Pakistan

At the same time, governments are already embarking in massive money printing (quantitative easing), stimulus and bailouts spree. As we said before in Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view,

… while the deflationary pressures will continue, it can be slowed down via unconventional monetary policies (see ?Bernankeism and hyper-inflation?), gigantic fiscal policies, bailouts and even government fraud. The result will be a long drawn out affair, akin to a grinding trench warfare and a war of attrition on the real economy as credit contraction (IOU destruction) collide head on with money printing, massive government spending, stimulus and bailouts.

If government pumps so much money into the financial system, it is only a matter of time before asset prices rise again, not because of improving economic outlook but because of the sheer weight of money. The problem will be massive consumer price inflation once the Global Financial Crisis (GFC) is over, which is a problem for the next generation to solve. The outcome will be what we wrote in Zimbabwe: Best Performing Stock Market in 2007?.

In any case, no matter what happens, the peak of economic boom in 2006/2007 is over and will not be back soon. Investors who are expecting that will be disappointed.

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  • Pete

    Nice article Ed, thank you 🙂

    It actually gets mentally harder to be a bear when everyone else is a bull. There’s that ‘herd mentality’ thing, and the (false) notion that the masses know better than the individual.

    Thanks for sticking in there and looking at the facts instead of running off with the herd like a lot of other people have.

  • Pete

    Nice article Ed, thank you 🙂

    It actually gets mentally harder to be a bear when everyone else is a bull. There’s that ‘herd mentality’ thing, and the (false) notion that the masses know better than the individual.

    Thanks for sticking in there and looking at the facts instead of running off with the herd like a lot of other people have.

  • David

    hi CIJ,
    You wrote, “If government pumps so much money into the financial system, it is only a matter of time before asset prices rise again, not because of improving economic outlook but because of the sheer weight of money. The problem will be massive consumer price inflation…” This made me wonder. If there is price increases in daily necessities, food, clothing, gasoline, and the like at the same time as high unemployment, would this tend to make families return to larger scale living groups. Basically, if Aunt Jane and Uncle Bill have a big, big house and are unemployed, meanwhile there are a bunch of other family members who are happy to be employed but tired of paying high rent or a mortgage on an underwater house, they might all move in together like olden days when multi-generational and large families all lived together. It would save money and help everyone out. But what would this do to already soft housing prices? Make them softer, so it seems like higher unemployment with higher commodity prices can lead to increases in prices for somethings (daily necessities, food, clothing, gasoline) and decreases in asset prices of things people don’t need (extra houses, houses that you have to drive long distance to, real estate in general, stocks in general, etc). Does this seem likely?

  • David

    hi CIJ,
    You wrote, “If government pumps so much money into the financial system, it is only a matter of time before asset prices rise again, not because of improving economic outlook but because of the sheer weight of money. The problem will be massive consumer price inflation…” This made me wonder. If there is price increases in daily necessities, food, clothing, gasoline, and the like at the same time as high unemployment, would this tend to make families return to larger scale living groups. Basically, if Aunt Jane and Uncle Bill have a big, big house and are unemployed, meanwhile there are a bunch of other family members who are happy to be employed but tired of paying high rent or a mortgage on an underwater house, they might all move in together like olden days when multi-generational and large families all lived together. It would save money and help everyone out. But what would this do to already soft housing prices? Make them softer, so it seems like higher unemployment with higher commodity prices can lead to increases in prices for somethings (daily necessities, food, clothing, gasoline) and decreases in asset prices of things people don’t need (extra houses, houses that you have to drive long distance to, real estate in general, stocks in general, etc). Does this seem likely?

  • Hi David!

    We think this is a highly possible scenario. But for now, the culture here is still dead set against large communal living. It will take a very severe economic crisis (consumer price rise + rising unemployment) to force a cultural shift. In addition to rising unemployment, peak oil and rising energy prices can push this towards such a shift. There may not be a housing ‘shortage’ in Australia after all if we count the number of rooms per person- a surplus may even be possible! When that happens, the ‘demand’ for housing will decrease.

    The good thing about such a shift is that people will have to re-learn to live with each other and to share.

  • Hi David!

    We think this is a highly possible scenario. But for now, the culture here is still dead set against large communal living. It will take a very severe economic crisis (consumer price rise + rising unemployment) to force a cultural shift. In addition to rising unemployment, peak oil and rising energy prices can push this towards such a shift. There may not be a housing ‘shortage’ in Australia after all if we count the number of rooms per person- a surplus may even be possible! When that happens, the ‘demand’ for housing will decrease.

    The good thing about such a shift is that people will have to re-learn to live with each other and to share.

  • David

    Hi CIJ,
    Thanks for the response. I think when unrelated people share a home it is called “house pooling” like car pooling but for living. It is a great idea for a bunch of single older people in a neighborhood to pick one house to ultra insulate and get an efficient heating system for, then all live together in the colder months. In summer they can go back to their own homes and garden till the first frost then bring all the storage crop produce to the root cellar at the group house, and turn everything off at the summer place. Once energy cost are higher this will seem like a more and more normal thing to do.

    The great thing about the crisis we are in, is that we will all re-learn what community is and what it takes to sustain it. The last few generations have lived isolated lives, and that is going to come to an end soon, I suspect. I agree we are not at that point yet, but unemployment and price increases on daily needs will bring people together. That will be the legacy of this downturn–that is not at all a bad outcome. Getting there will be the painful part the more we try to put it off instead of embrace it.

  • David

    Hi CIJ,
    Thanks for the response. I think when unrelated people share a home it is called “house pooling” like car pooling but for living. It is a great idea for a bunch of single older people in a neighborhood to pick one house to ultra insulate and get an efficient heating system for, then all live together in the colder months. In summer they can go back to their own homes and garden till the first frost then bring all the storage crop produce to the root cellar at the group house, and turn everything off at the summer place. Once energy cost are higher this will seem like a more and more normal thing to do.

    The great thing about the crisis we are in, is that we will all re-learn what community is and what it takes to sustain it. The last few generations have lived isolated lives, and that is going to come to an end soon, I suspect. I agree we are not at that point yet, but unemployment and price increases on daily needs will bring people together. That will be the legacy of this downturn–that is not at all a bad outcome. Getting there will be the painful part the more we try to put it off instead of embrace it.