Four-Legged Bull: 1 Year and Counting

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Four-Legged Bull: 1 Year and Counting
Fidelity Viewpoints
By Jurrien Timmer, Director of Investment Research and Co-Portfolio Manager of the Fidelity Dynamic Strategies Fund

March 17, 2010

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Last week, the markets celebrated the one-year anniversary of what could, in my opinion, turn out to be the generational low of our time—667 on the S&P 500® Index. Fast forward to March 15, 2010, and the S&P had risen 70% to 1,150. Now some investors are worrying about a double dip. But from the weight of the evidence, my personal opinion is that the bull market may have room to run—at least in the near term.

Looking back
I remember the March 2009 low as if it was yesterday. The stage had been set technically for a primary bottom: a fifth wave down according to the Elliott Wave counts (a technical measure based on wave patterns that pointed to 650 on the S&P 500), and massive divergences in high yield, commodities, and emerging markets. Many investors were worried. Time magazine had a "Holding On for Dear Life" cover, and the Wall Street Journal had an above-the-fold cover story with the headline "Dow 5,000?". These kinds of bearish stories can sometimes pinpoint market extremes.

Fundamentally, the market was trading at a mere nine times forward earnings. A dovish Depression-era scholar at the helm of the Fed was committed to avoiding a repeat of that devastating period in history. But the new administration was just starting to find its way. The market was scared to death about banks being nationalized, and nobody knew how to handicap their upcoming stress tests. All we needed for stocks to bottom was a catalyst, like the end of mark-to-market accounting, or the much anticipated stimulus bill, or a Fed willing to print money.

And so the four-legged bull was born.

The technicals were ripe, sentiment was ripe, and the monetary and fiscal stimulus gears were already churning. All that was left were the fundamentals, which were pretty depressing at the time. But, those depressing fundamentals were more than discounted.

At the end of the day, it seemed to come down to one question: Were we headed for another Great Depression or would we get something less severe? The market was certainly pricing in another depression, which meant that if we didn't get it, it would need to reprice itself higher. In my opinion, that was what the crash and subsequent recovery came down to: a market pricing in a worst-case scenario and getting something better.

Looking ahead
OK, enough reminiscing. Where are we going? In my opinion, the weight of the evidence continues to lean bullish. Reviewing the four legs of the bull, my conclusions are as follows:

Economic recovery. I believe the economic recovery remains on track. This continues to be the Rodney Dangerfield recovery in that it gets no respect. It continues to amaze me how few people are willing to even acknowledge that a recovery is at hand. But, leading indicators continue to point to more growth ahead, and earnings have been blockbuster. So, this leg remains very strong.

The one fly in the ointment is that those same leading indicators have now peaked. But, since the level is still high and the lead time is a good 6 to 12 months, it suggests that there is plenty of growth still left.

Easy money. This one is trickier. While the twin liquidity spigots of quantitative easing and deficit spending remain wide open with a tremendous amount of stimulus already in the pipeline (remember that monetary policy operates with a lag), there is no question that the rate of change has peaked, at least as far as Fed policy is concerned.

While I am not at all worried that the Fed will tighten too soon, I am worried that the end of quantitative easing could turn out to be a form of de facto tightening. The Fed's program of buying long-term assets (mortgage-backed securities [MBS] and government agency bonds) is coming to an end this month, which means that the bond market will lose this vehicle of support. Think of it as the patient getting off life support. Hopefully the economy is strong enough to survive widening spreads and rising bond yields, but it's a major open question right now.

My gut feeling is that the economy (and therefore the market) will be OK for a while when yields start to tighten. After all, bond yields have been positively correlated to stock prices for over a decade now (since the fall of Long Term Capital Management). So, if the ten-year Treasury yield backs up through 4% to say 4.5%, that shouldn't be particularly harmful as long as the backup occurs for the right reason (i.e., a stronger economy).

It remains an open question, especially for the dollar and commodities, because they are on the opposite ends of the liquidity trade. In other words, more liquidity means a lower dollar and rising commodity prices and vice versa.

Sentiment. This continues to be the rally that investors love to hate, and as a result, the market has climbed a huge wall of worry. By mid-January, some of the surveys showed the market had been overbought, but the recent 9.2% correction shifted the balance of bulls to bears. At the lows, the Daily Sentiment Index (DSI) for the S&P 500 had fallen from 85% bulls to only 33% bulls.

Now with the market recovering again, those surveys are once again getting a little overbought. The DSI is back up to 71%, and the Investors Intelligence survey shows 42% bulls vs. 23% bears. The ISI hedge fund survey is getting up there as well.

But, the indicator that counts the most—what investors are doing with their money as opposed to what they are saying—remains constructive. While AMG Data Services is reporting a few weeks in a row of equity fund and exchange-traded fund inflows, the amounts are modest and they follow five weeks of consecutive outflows.

The lack of optimism on the part of investors remains noteworthy given the 70% gains in stocks, but it is not totally surprising given the trauma that investors were subjected to in 2008. This is Behavorial Finance 101.

The question that remains is whether this cyclical bull market will end with a whimper or a bang from the perspective of sentiment. Usually it ends with a bang, that is, a strong inflow of money as investors capitulate to the bullish side. But perhaps this one will be like the 1970s, a period when many investors checked out of the equity markets for good (or at least until the next secular bull market).

A lot will depend on what investors do with the $385 billion that they poured into the bond market over the past 12 months (according to data from the Investment Company Institute). That is a staggering amount of inflows for bonds. Given that interest rates have been held down in part because of the Fed's quantitative easing, it will be interesting to see if yields start to rise in the months ahead and whether that prompts investors to flee bonds and chase stocks. That is often the way the story unfolds, but it's by no means a foregone conclusion. Perhaps this time around those flows will be stickier than usual.

Technicals. Last but not least, the technicals have gone from great to good to fair to good and now back to great, in my opinion. How great?



As you can see in the chart above, the recent correction ended where it was supposed to—above support at 1,025 on the S&P 500. That level is the low from last fall. A decline below it would change the pattern of higher lows that has been in place for a year. As a result, the pattern of higher highs and higher lows, as well as a rising 200-day moving average remains in place.

The advance-decline is at a new recovery high (see chart above). While a new high in January failed to prevent the 9% sell-off, the fact remains that it is very unusual to see a major top without some serious divergences between breadth and price. We are not seeing any signs of this, which suggests to me that any top is several months away.

Rarely do we see a major top without the new lows list expanding. And there are few if any new lows. Both the NASDAQ Composite and the Russell 2000 are now making new cycle highs, as is the total return for high yield and the Bloomberg Financial Conditions Index (BFCI). Tech and small caps have been among the leaders for this cycle. The fact that they are once again leading is quite bullish, in my opinion. A look at the chart of the relative performance of tech vs. the market shows a massive multi-year base (see below).



Copper is almost back to its high, the dollar rally has stalled out, and credit spreads are once again tightening, including sovereign CDS spreads. CDS, or credit default swaps, are a form of credit insurance that investors can buy to protect their bond holdings from default. In fact, the chart of sovereign CDS spreads is about as bullish as it gets (see below). The first spike in Greece CDS put in the low for stocks (a "hammer" on the candlestick chart), and the second spike was lower than the first (putting in the second hammer). Even better, that second spike was not accompanied by a widening in CDS spreads for the UK, Japan, or the US. From a technical perspective, that's a bullish sign. I also see it as a clear sign of a lack of contagion. Now Greece CDS has tightened below the support level of 350 basis points (3.5%), indicating a clear peak (see graph below). Is the sovereign CDS storm over?



From a technical perspective, we've also seen a head and shoulders formation (see graph below). Now a second bottom is evident, on top of the big one formed last year. So, we continue to have unresolved higher price objectives for the market.



And don't forget that one of the most bullish seasonal periods is upon us (March to May).

Risks ahead
With the economy getting stronger, sentiment still skeptical, and the technicals in great shape, for me the main thing to focus on is what the end of easing will mean for the markets. Not the beginning of tightening mind you, for that is likely a long ways off, but the end of easing and specifically the end of quantitative easing (QE).

Like a patient having his IV drip taken way, the consequences of the end of QE will be determined by whether the budding economic recovery is sustainable or not. To me that is the BIG question. The patient is recovering, but is he recovering only because he is heavily medicated? In other words, will the patient continue to recover after the IV drip is removed or will he relapse into a coma?

So what are the indicators to watch for signs that the Fed is succeeding in withdrawing its stimulus without precipitating a market relapse? New highs in commodities would be nice because commodities are fueled by liquidity. Further strength in the dollar could be bad, as that is on the other side of the liquidity trend.

Credit spreads remain an important leading indicator as well, and I believe it is a positive sign that high yield spreads have narrowed again to the mid 600s after reaching the low 700s. Their cycle lows were in the low 600s.

The yield curve is also important. If short rates start to rise (market rates, that is), then the yield curve could flatten, which would be another form of market tightening.

I am also watching the growth rates in the money supply. The monetary base (M0) has been growing as a result of quantitative easing. But M2 and M3 (measures of money in circulation, including savings and checking accounts and money market funds) have not grown, although their lack of growth is probably overstated by the exodus from money market funds. So, I find it hard to argue that the money multiplier is expanding rapidly and that inflation is right around the corner. I believe deflation is more likely.

The lack of money supply growth is compounded by the fact that the banks are not lending, and if that continues even though the Fed is no longer medicating, then I believe it is hard to see the economic recovery becoming sustainable. So, bank lending is an important indicator to watch.

Bottom line
The four-legged bull is now one year young and there are signs that it could continue its run. With the economy recovering and both sentiment and the technicals in good shape, the thing I will be most focused on in the weeks and months ahead is whether there will be a de facto tightening of liquidity and whether the economy will be strong enough to withstand such a tightening.



The information presented above reflects the opinions of Jurrien Timmer, Director of Investment Research and Co-Portfolio Manager of the Fidelity Dynamic Strategies Fund, as of March 17, 2010. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based upon market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.

Past performance is no guarantee of future results.

Investing involves risk, including risk of loss.

All indexes are unmanaged, and performance of the indexes includes reinvestment of dividends and interest income, unless otherwise noted. The indexes are not illustrative of any particular investment and it is not possible to invest directly in an index.

Nasdaq Composite Index is a market capitalization-weighted index that is designed to represent the performance of NASDAQ stocks.

Russell 2000 Index is a market capitalization-weighted index of the stocks of the 2,000 smallest companies included in the 3,000 largest U.S. domiciled companies.

S&P 500® Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

The Bloomberg Financial Conditions Index combines yield spreads and indices from the money markets, equity markets, and bond markets into a normalized index.

It is not possible to invest directly in an index.

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