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World’s Greatest Investor Turns Bearish on Stocks, 25% Drop Next?

Stock-Markets / Stocks Bear Market Oct 30, 2009 - 01:56 PM GMT

By: Q1_Publishing


Best Financial Markets Analysis ArticleThe recession is over!

GDP grew at a 3.5% clip between July and September.

Wall Street’s fortunes seemingly turned around overnight.

But with the rally reminding everyone how fragile it is, are the boom times really here again?

One of the world’s best investors thinks it will seem that way for a while, but - that could be bad news for the markets. Here’s why.
World’s Great Investor Turns Bearish

Six months ago almost no one believed in the rally. Unemployment was still on the rise. The economy was still contracting. The housing market, despite all kinds of incentives for buyers, ground to a standstill.

There were no fundamental reasons for stocks to rally. There were, however, a few technical reasons.

The combination of low expectations and trillions of new dollars pumped into the system would create a run in whatever asset class was on the rise. Once stocks broke out in March, the hot money would chase them back to reasonable valuations and beyond.

Back in April we proposed the Dow hitting 10,000. It seemed a bit unrealistic at the time, but given the situation, anything could happen. We weren’t the only ones who saw it that way though. One of the most successful investment managers in the world, Jeremy Grantham, saw it similarly.

Now, Grantham considers the market 25% overvalued and is taking some money off the table and you must understand why.

Frustrating Times Ahead

In his most recent quarterly letter (a must read for any investor), he brought up one very important point (emphasis mine):
The 1Q 2009 Quarterly Letter, by the way, said “in a [S&P 500] rally to 1000 or so, the normal commercial bullish bias of the market will of course reassert itself, and everyone and his dog will be claiming it as the next major multi-year bull market.”

Well, now it’s happened precisely that way, and you should not believe them! As we have demonstrated to our clients in earlier cycles, earnings estimates in particular merely follow the market up (not the other way around, as one would hope). So it is a law of nature that strong estimates will abound after a major market rally.

The earnings and economic growth estimates in such cases are usually throwaways. But the economic data next year will indeed look strong.

The irony may well be that just as nine months of weak economic data this year has been accompanied by a very strong market, so the strong economic data next year is likely to be accompanied by a weak stock market.

Think about that for a second.

Most everyone isn’t quite calling for a “multi-year bull market,” but everyone seems to agree the rally has been fueled primarily by aggressive monetary expansion (money printing) and hopes of a recovery.

Now that the masses have realized that, no one is willing to bet against this rise and many more are jumping on board. Meanwhile, the economic data continues to improve (today’s GDP growth numbers were the most positive yet) and the market’s have started show some genuine weakness.

Aside from today’s sharp rise, the markets have climbed in anticipation of good news ahead rather than on good news. As a result, we can conclude they’ve reached the dangerous point of expectations which may be too high.

So what’s going to happen when that good news comes?

As we know, when expectations are great, the risk/reward situation turns upside down.

If the news is really good, the markets may hold up or even go a little bit higher. If the news is not good, they will falter - quickly.

Markets ALWAYS Revert to the Mean

That’s the real risk here. Right now, there’s not much holding this market up besides high expectations.

That’s why, although we don’t foresee a crash like last September or November coming, we do realize the markets have hit an unsubstantiated high. This will lead to a terribly frustrating market for many investors.

Investors who refused to take what the market gave them months ago missed out on a lot. They’re now forced to play catch-up. And with the economy looking better, they won’t mind shoveling more money into the markets.

That’s where the frustration will come in. There’s no doubt the economic numbers will improve. But the markets will not have to go up because almost all of it is already anticipated.

If you consider Grantham’s fair value for the S&P 500 of 860, the overall markets could have another 20% to 25% downside over the next six to nine months even if the economic news is good. If we use his 860 as the average – or mean – the markets could easily revert to that level even while the economic data shows steady improvement.

No True Recovery in Sight

Although the markets will continue to be volatile, we can’t forget we’re undoubtedly entering a period of slow growth.

Yes, the housing market will recover. The government extension and expansion of the homebuyers’ tax credit will help accelerate this in the short-term. But it won’t return to the bubble era anytime soon. (Side note: we’ll go over this situation in detail and how to maximize the opportunity in the next Prosperity Dispatch)

On top of that, it’s looking like the bailouts will continue indefinitely. This week the government announced it will be putting more cash into GMAC for more auto loans and leases, which is nothing more than a backdoor bailout to GM and Chrysler. Also, the dairy and beef industries have gotten bailouts too. Both of these appear helpful in the very short-term, but they merely stave off the natural, inevitable, and necessary right-sizing of the industries to put them back in a sustainable state.

Then there are the unintended consequences of healthcare reform, the impact of higher taxes, and the greater involvement of government across the business landscape. They will all weigh on the economy too.

So although we’ve been as positive as we can reasonable get here, we try to stay realistic too. Today’s GDP numbers were great. The rally was great. But the good news will lead to higher expectations. And we all know before great disappointments comes great expectations.

The recession may be over, but that could mean trouble ahead for stocks. At the Prosperity Dispatch, we’re not about to bet against an uptrend. Now is the time to tighten up stop-losses and be prepared to move when necessary. There’s a very realistic chance of the S&P 500 falling 20% in the next six to nine months even if the economic numbers continue to improve.
Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Disclosure: Author currently holds a long position in Silvercorp Metals (SVM), physical silver, and no position in any of the other companies mentioned.

Q1 Publishing is committed to providing investors with well-researched, level-headed, no-nonsense, analysis and investment advice that will allow you to secure enduring wealth and independence.

© 2009 Copyright Q1 Publishing - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

Q1 Publishing Archive

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


31 Oct 09, 16:31
"... worlds greatest investor turns bearish."

Seems like darker shades of VOODO ECONOMICS to me.

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