Investors beware, ’tis a sucker’s rally

“The more I think about it, the more interesting it becomes that sentiment has turned bullish so quickly. When bear markets really bottom, sentiment is so negative that it really feels like the blood is not only in the streets, but that we are haemorrhaging from every orifice with nary a tourniquet in sight. That hasn’t happened yet.” —Richard Russell, one of the world’s most revered investment letter writers, who has been publishing Dow Theory Letters since 1958

“You have become a scaremonger,” she said.

“Yeah. But isn’t one man’s scaremonger another man’s realist?” I asked.

“I was looking at some numbers and realised that most stock markets around the world have rallied big time since the beginning of March. Take the Bombay Stock Exchange Sensex, which has risen by more than 20%. The Dow Jones Industrial Average, the oldest stock index in the world, has given a return of 11% since the beginning of March. And here you are, going on and on as if the world is about to come to an end.”

“Ever heard of a term called ‘dead cat bounce’?” I asked.

“I thought we are discussing the stock market. Why are we suddenly talking about cats?”

“Let me explain. A dead cat bounce is a term used to describe rallies in a bear market. It comes from the notion that even a dead cat bounces if its falls from a great height. Most bear markets are characterised by these dead cat bounces. Take the Great Crash of the stock market that happened in October 1929 and which ultimately led to the Great Depression. Between 1929 and 1932, Dow fell by around 90%. But during that period, there were six rallies in which the stock market gave a return of more than 20%. Every time there was a renewed sense of optimism among the investors, but each time the rally went kaput and the market touched new lows.”

“Rather interesting. But what makes investors get back into the market time and again?” she asked.

“I think it is a matter of hope. When everything was rallying, investors believed nothing could go wrong. That is why the world over stock markets went up and so did property prices. Over the last 15 months, the process has reversed. Stock markets have fallen with a thud, and so have property prices. But investors still have an iota of hope left in them. So every time stock prices go up a little, investors come up with stories that they tell themselves, to convince themselves that everything will be fine, and that the good old days will be back. The business media picks this up, and builds on it. If you have realised, anchors of business news channels have been smiling a lot more in the last few days.”

“So what is the story investors are telling themselves this time around?”

“That combined government action will save the world, and its financial markets. The latest episode in this story is the meeting of the leaders of the Group of Twenty (G-20) which happened last week. They announced a $1.1 trillion stimulus for the International Monetary Fund (IMF) and other international institutions. This has made investors across the world happy. They don’t realise that the financial meltdown has destroyed investment capital of around $50 trillion. So what difference is a little over a trillion dollars going to make? Also, as one journalist put it, 20 leaders of G-20 spent 220 minutes in London, discussing the crisis, which means each leader had precisely 11 minutes to put across his point of view.”

“Eleven minutes?” she interrupted.

“Actually, it was much lesser, considering there were ten other leaders from organisations like the IMF, Association of South East Asian Nations and the Financial Stability Forum, etc also attending the meeting. So, there were thirty leaders and a total of 220 minutes to discuss the entire issue, which means a little over seven minutes per leader. Not a huge amount of time. Hence, expecting them to come out with anything substantial in such a short period of time would be outright foolish.”

“What of the economy? Isn’t that supposed to recover in the days to come?”
“Ultimately everything recovers; the question is —- when? That nobody really knows, and at best, the so-called experts are guessing. Let me give you the example of Japan. Exports for March are down 49% from the same time a year back. Exports to the US, Japan’s largest trading partner, collapsed by 58.4%. Industrial production was down 9.4% in February and the economy contracted 12.1% in the first three months of the year. All this is forcing companies to cut jobs and salaries. Salaries have come down by 3.5% from a year back. Investors in Japan have ignored all the negative news and the Nikkei-225 index has rallied 17.8% since the beginning of March. They are betting on an export-led recovery in the second half of the year. The Japanese economy may be an extreme example, but the situation is no different in other parts of the world as well, with the economy contracting and massive job losses.”

“You are scaring me even more now.”

“Maybe, but that is the way I see it. Also, a point to remember is that as more and more people lose their jobs all over the world, there will be more loan defaults, and a further slowdown in spending, which will impact corporate profits. This, in turn, will lead to more job losses and a further slowdown in spending. An important point to remember is that till now, the United States has the main source of demand for the world economy. And the American consumer is clearly not in a mood to buy either goods or services right now.”

“What are you hinting at?” she asked.

“Stock market performance ultimately rests on hopes of future corporate performance. And if investors don’t buy goods and services, companies can’t make profits. Meanwhile, investors are stuck with delusional optimism. By the time they come out of it, they would have lost a few dollars more. Or should I say rupees? P T Barnum, an American showman, once famously said, “There’s a sucker born every minute.” Rallies in bear markets are sucker’s rallies. Now can you tell me what people who invest only on the basis of such rallies are called?”

References: Speculators Return to Commodities, Aussie and Canadian Dollar, Gary Dorsch,  ww.safehaven.com, April 2, 2009; Junkets, Boondoggles, and Faith, Gary North, www.lewrockwell.com, April 4, 2009; G20 leaders get 11 minutes each to save capitalism, www.marketwatch.com, April 2, 2009; A Sucker’s Rally and Bear Market Surprise, Bill Bonner, April 7, 2009, www.dailyreckoning.com.