Introduction

Stock markets declined the first two days of this week, beset by a spate of bearish remarks from various commentators. The declines came after five weeks of gains, which have led investors to speculate that the markets’ recovery is really the beginning of a new bull market.

Various market prognosticators, however, have posited that the increases were only a bear-market rally, that enough bad news still lay ahead to prevent any sustainable recovery.

On Wednesday, the markets bounced back and finished the shortened trading week with a strong performance, with the major indices (the Dow and the S&P 500) each gaining close to four percent on Thursday. Since March 9, the most recent low point for the averages, the Dow has gained more than 23 percent, while the S&P 500 is up over 26 percent.

S&P 500 Index - One Year Chart

The question faced by investors is: who is right? The gloom-and-doom merchants or the bulls?

The Bad News

The markets received their first jolt on Monday, when Mike Mayo, an analyst now with Calyon Securities (and most recently with Deutschebank) initiated coverage at his new firm on eleven bank stocks. Mayo had made a name for himself back in 1999, when he took a bearish stance, correctly it turned out, on banking stocks while most analysts were still overwhelmingly bullish.

On Monday, Mayo assigned an "underweight" rating to the banking sector with "underperform" labels on Bank of America and JP Morgan Chase.

Mayo said that loan losses at banks might exceed levels achieved during the Great Depression. He also maintained that the government may be forced to take over a number of large banks. According to Mayo, bad loans have so far only been marked down to 98 cents on the dollar, on average, much less than they should have been.

Mayo expects loan losses at US banks to increase to 3.5 percent of all loans (and could increase to 5.5 percent should the economy further deteriorate) by the end of 2010. During the Great Depression, loans losses reached a high of 3.4 percent in 1934.

He feels that nationalization of banks remains a real possibility because government policy remains unclear.

As a result of Mayo’s comments, bank stocks fell across the board Monday, led by Bank of America, which was down 1.6 percent, and JP Morgan Chase, down 3.7 percent. The decline in bank stocks dragged the whole market lower.

On Tuesday, George Soros added fuel to the fire when he maintained that the current market rally was only a "bear-market rally," because the economy was still shrinking. Soros said that "this isn’t a financial crisis like all the other financial crises we have experienced in our lifetime." Soros argues that the housing market hasn’t bottomed yet and added that the recent change to fair value accounting (removing the requirement to mark troubled assets to the market) will only serve to keep troubled banks in business.

The third bear to weigh in on the markets was Nouriel Roubini, chairman of economic research firm RGE Monitor and a professor at New York University’s Stern School of Business. Nicknamed "Dr. Doom" for his bearish outlook on the markets, Roubini predicted that the bear market would continue. "There is a light at the end of the tunnel somewhere down the line, later rather than sooner." He expects macro news, earnings news and financial shocks to all be worse than expected.

A report in the Times of London that the International Monetary Fund (IMF) would soon raise its forecast of the level of toxic assets on financial institutions’ balance sheets to $4,000 billion, worldwide ($3.1 trillion on the books of US banks and another $900 million on the balance sheets of foreign banks), added to the bearish outlook.

Finally, the Federal Reserve, in releasing the minutes of its last FOMC meeting, revealed that it had lowered its own GDP estimates for the second half of 2009. According to the Fed, "Real GDP is expected to flatten out gradually over the second half of this year and then to expand slowly next year."

The Good News

The markets’ rally later in the week came on speculation that government measures so far enacted to revive economies and rescue financial firms are working. The rally was also triggered by an earnings surprise from Wells Fargo. Wells, which was the largest recipient of TARP funds from the Treasury, said it expected net income of $3 billion in the first quarter, and earnings of 55 cents a share. The earnings exceeded analysts’ expectations. Last year, Wells earned 60 cents a share in the first quarter. Wells’ stock jumped 27 percent Thursday and led the rest of the banking sector higher.

A second factor pushing stocks higher was a report that all nineteen banks, tested by the Treasury, would pass their stress tests (although banks have been warned by Treasury to remain mum on their test results).

Finally, a smattering of bullish comments also lifted markets. Robert Doll, chief investment officer at BlackRock Inc. said his firm felt the "worst of the recession was in the rearview mirror" and analysts at JP Morgan Chase said "seeds of recovery are beginning to sprout." The analysts at JPM said they believed the global consumer was continuing to spend. This, they felt, would induce producers to start restocking by summer. They pointed to mid-summer when both the US and world economies would stop contracting.

The Outlook

We believe there are three areas that are key to economic recovery: corporate earnings, the housing market, and the improvement in bank balance sheets.

The earnings outlook is not bright. Three months ago, the consensus of analysts was that earnings were expected to fall 13 percent, year-on-year, in the first quarter. The consensus now, as earnings begin to be reported for the quarter, is for earnings to be 40 percent lower. Corporate earnings are down 82 percent from their June 2007 peak, worse than the collapse in earnings that occurred during the Great Depression. The good news is that first quarter earnings will be up when compared to their fourth quarter counterparts, but only because fourth quarter results were so bad.

Some analysts argue that the market bottoms out, on average (going back to1949) six months before earnings bottom out. So, if earnings do in fact bottom out this summer, then the bottom achieved in stocks in March may have been the turning point in the market.

The housing market is also showing signs of a bottom (although the outlook, at this point, is not exactly robust). All the most recent housing indicators (with the exception of the Case-Shiller Index of Home Prices in 20 US Cities) showed improvement in February. Housing starts rose 22 percent in February, an annual rate of 583,000 (analysts had expected an increase to 450,000), new home sales gained 4.7 percent, to 337,000 (expectations were for 300,000), and pending home sales were up 2.1 percent (analysts had expected February’s numbers to be the same as January’s). The Case-Shiller Index fell 19 percent in January (February’s figures had not been released yet). In addition, mortgage applications rose 4.7 percent in the week ending April 3.

A recovery in housing is one of the factors that will be required for a recovery in consumer spending. A one-month improvement in figures does not constitute a trend, but one can keep one’s fingers crossed.

The recovery in financial institutions’ balance sheets remains a question mark. Two weeks ago, we pointed out the potential problems with Treasury Secretary Geithner’s toxic asset plan. As far as we are concerned, the jury is still out.

There are other factors that will contribute to the recovery. Some economists (and bears) point to the fact that unemployment numbers will continue to rise for a few months more. This will occur because firms will continue to lay off workers. However, we believe the numbers of jobs lost per-month will begin to decline in the second quarter. We believe the November-January numbers will have been the worst that we will see.

On balance, while we remain cautious, we feel the worst of the recession is behind us. We look for the economy to bottom sometime in the next two quarters. We feel that a recovery, however, will not be that robust, because households continue to de-leverage and consumer spending will be less than hoped-for. Nevertheless, we think there will be an economic recovery of sorts and, therefore, think the current market rally could be the real McCoy.

Legal Disclaimer: Any opinions, news, research, analyses, prices, or other information contained on this website is provided as general market commentary and does not constitute investment advice.

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