Where to from here?

PORTFOLIO POINT: Morgan Stanley strategists at least agree this is a bear market rally. They diverge on how far it might run.
Eureka Report editor James Kirby writes: Will the rally – even if it is a bear market rally – extend from here? Today we've managed to intercept a fascinating dialogue between our favourite bear, Gerard Minack of Morgan Stanley, and several of his colleagues from within the investment bank on Wall Street.

The e-mail conversation (we're reprinting a shortened version) offers a unique insight into what market insiders are thinking about the surge in equities we have enjoyed in the past few weeks. The dialogue occurred over several trading days last week, and although Wall Street finished flat overnight Friday, the key themes highlighted in the transcript will not change.

Among the key “takeaways” from the dialogue is that the majority of brokers don't believe this rally represents a serious change of temperament in the markets. However, as Gerard's colleague Laurence Mutkin suggests: "The S&P 500 can rally to as high as 1000 without breaking the bear trend." The S&P 500 is currently at 768.

Gerard Minack takes up the story '¦

Most Morgan Stanley strategists are sceptical about the rally in equities. We are, however, debating its significance. Here's an email discussion:

Gregory Peters (chief credit strategist): I am having a hard time seeing this rally sticking in equities. Mortgage-related products have continued to trade down (all-time lows), credit spreads are weaker, and LIBOR markets continue to see steady deterioration. Yet stocks are rallying (Exhibit 1). I really don't understand how this rally in stocks can be sustained unless these important risk measures are incorrect. What gives?

Joachim Fels (chief economist, global fixed income): Could this be the excess liquidity created by near-ZIRP (Zero Interest Rate Policy) and, more importantly, quantitative easing? This has to go somewhere. It's natural that people won't go back into the stuff that got us into trouble in the first place (mortgages, credit, etc), and stocks are a simple product that people understand.

Jason Todd (executive director, Greater New York City Area): The rally coincided with positive comments from bank chief executives (Messrs, Vikram Pandit of Citi Group, Jamie Dimon of JPMorgan, and Kenneth Lewis of Bank of America) that set the financials off.

To Greg's point, I think disconnects go even further. If concerns about growth have fallen, then I'm surprised the US dollar has held in so well, that the VIX (exchange volatility index, a popular measure of the implied volatility of the S&P 500) remains so elevated, and investment-grade credit spreads have done little since the rally that ended in January.

Moreover, precious metals remain reasonably well bid, while base metals have not really participated. Similarly, the traditional high-beta sectors and markets (the SOX index of the semiconductor sector; tech hardware; Asian tech-heavy markets) have not been strong outperformers since the S&P 500 troughed (yes, they have on a year-to-date basis, but we are talking about the past two weeks). Industrials have rallied hard (up 13%), but GE is up 40% and accounts for a lot of this.

Finally, if the US benefited from risk-aversion flows as a large-cap growth market and outperformed Europe this year, despite being the cause of many problems, I am yet to see a reversal in this trend (Asia aside).

Ted Wieseman (economist, US fixed income markets): I'm puzzled about how all these banks can be saying they're going to make money in the first quarter (which appears to have been a key driver of the stock rally) given what's been going on in these various markets. Are they only talking about operating results? Because the first quarter mark-to-market for commercial real estate, subprime, leveraged loans, et al. look like they're just going to be brutal based on the various Markit derivatives' year-to-date performance.

Greg Peters: Bingo – and credit spreads for financials are wider, too (which perversely boosts earnings). The fact is that all these products are trading off due to policy uncertainty, etc. Yet the financial stocks – which are essentially a roll-up of these products – are higher. That makes very little sense.

David Greenlaw (chief economist, US fixed income markets): But isn't the value of the equity component of most of the financials now so small that it essentially represents a call option? The value of that option has risen due to:

1) Chief executives and others noting that core business is profitable (as our US bank analyst Betsy Grasek has been emphasising); and

2) because [US Federal Reserve chairman Ben] Bernanke and other policy makers have effectively ruled out nationalisation, so equity holders may be able to ride out further writedowns. (It's worth noting that the policy message on nationalisation has not ruled out the possibility that private equity holders will be wiped out, but this has been lost in the shuffle).

The positive spin has been self-reinforcing in the equity world, and you wind up with the big disconnect.

Still, I'm getting more and more worried that the political climate will limit the ability of the government to continue to inject capital into the financial system as write-downs inevitably mount in response to deteriorating credit. This is highlighted by the type of indexes that Ted cites which are likely to continue to move lower as long as the real economy is getting worse.

Laurence Mutkin (head of European fixed interest strategy): The S&P 500 (SPX) can rally to as high as 900–1000 without breaking the bear trend, so it's not surprising you have lots of asset classes still looking sick even as stocks go up. The fact is that stocks still are sick; they just happen to be going up.

But stocks, being the longest-duration assets, can discount an eventual far-in-the-future improvement even though shorter-duration assets like credit, mortgages, and (certainly) LIBOR can't – they're just not long-duration enough. This suggests you can reconcile the “disconnect” if you recognise it in terms of stocks looking farther out (beyond the recession) than many other asset classes can.

Gerard Minack (chief market strategist, Morgan Stanley Australia): I'd rate this as a standard bear-market rally. We always need to be ready to call a more significant low in equities, of course. But the giveaway signs for me are the sector performance and the speed. At the sector level, we're seeing what has fallen the fastest, bounce the hardest. Classic short-covering/bear-market behaviour. Speed is important: The fastest rallies are bear-market rallies.

Bear-market rallies are normal. Exhibit 3 is from Parin Gandhi. Compare this bear cycle and the last one. We've seen almost as many bear-market rallies in this cycle as in the last one, although this bear market is (so far) a lot shorter.

The big difference is the speed. Look at the average duration of 10%-plus rallies. In 2000-02, it was 20 days; this time it's eight days. I'd be more worried that we have passed an important low if we'd seen the recent gains over two months, not two weeks.

Teun Draaisma (head, European equity strategy): I very much agree it is a bear-market rally, and I also very much agree with the way Laurence puts it.

This rally is now seven (!) trading days old only, and 17% from closing trough in the S&P. Even between 1930 and 1932 there were five bear-market rallies of 20–35% lasting on average 35 days. The risk is that we suddenly start getting the longer and bigger bear-market rallies we saw in Japan. Bear-market rallies can only be sustained with hopes of successful policy action.

These things are meant to hurt, so they may go on a bit longer '¦ into April/May (20–35% up from trough) would be entirely usual, but the other risky assets need to improve a bit. I am not counting on further strength, and I think we will go to lower lows, but it may last a bit longer; seven days is nothing!

Near-term downside triggers – apart from corporate news – could be G20 disappointing on April 2.

Jason Todd: Maybe the biggest concern should be that we all believe it's a bear-market rally! Not one dissenter amongst us all.

Gerard Minack is chief market strategist of Morgan Stanley Australia.