Nine Reasons the Countertrend Rally May Be Over

After this positive earnings season, there's little to further catalyze the market to the upside. To the contrary, there are a number of factors -- many of them from abroad -- which, taken together, should apply considerable downward pressure on global financial markets throughout the remainder of 2009 and 2010.

Fundamental Factors

1. Reversal of the pent-up demand effect.

Perhaps the single most important fundamental insight that drove my countertrend rally prediction was that production and shipments had contracted far more sharply than underlying demand. Economists and equity analysts projected the October 2008-February 2009 production declines in a linear fashion into the future, and this produced massive estimation errors. It was clear to me that once the psychological panic phase had passed, production and shipments would not only normalize in line with true underlying demand, but there would also be a pent-up-demand effect that would “juice up” the economic and corporate data from March through June.

The pent-up-demand effect alluded to above has probably run its course. But that, in and of itself, isn't the main problem. The problem is : Economists and equity analysts have once again made the mistake of projecting linearly. They have taken second-quarter figures and projected forward from there. The problem is that the true level of normalized underlying demand is below that which was reflected in the data in the second quarter of 2009, due to the pent-up-demand effect. This means that once the pent-up demand effect wears off, demand will quickly settle back to a lower normalized level. Not only that, from this lower normalized level, aggregate demand is still contracting at a fairly rapid pace due to declining employment, real wages, and profits.

To sum up. The third quarter and particularly, the fourth quarter, are likely to bring substantial disappointments in economic data and corporate earnings.

2. Interest-rate sensitivity.

In March, investors were vastly underestimating the simulative effects that extremely low short- and long-term government-borrowing rates would have on the economy. High financial-services penetration and high levels of leverage in the US magnify the interest-rate sensitivity of the economy. Low rates provide fuel for investment and consumption in an economy where credit can be delivered through a wide array of mechanisms. In addition, refinancings increase disposable income for businesses and consumers that are highly indebted.

However, interest-rate sensitivity works both ways. And this means that as interest rates inevitably normalize -- i.e., long-term government bond yields move beyond 4.25% and above -- a major stimulative factor will be removed from the economy.

High levels of consumer and business leverage has put the economy between the proverbial rock and a hard place. Normalization of financial markets and an uptick in growth will essentially dampen the rate of recovery through the effects that an increase in interest rates will have on an interest-rate-sensitive economy.

The result of this conundrum will be sub-par growth and increased macro volatility.

3, The mess in Europe.

Europe is in trouble -- and more than is realized. Government debt in Europe is far greater than in the US. The demographics are dismal. Entrepreneurial growth dynamics are non-existent. Property values are significantly more overvalued than in the US. The corporate sector is considerably more leveraged than in the US. The banking system is much more leveraged than in the US and capitalization levels of banks are grossly inadequate. The monetary and fiscal mechanisms in Europe to counteract the economic crisis are lame.

Furthermore, the multi-party parliamentary systems of most European nations are dysfunctional. Europe is essentially one year behind the US in terms of the bursting of the property bubble and the financial-system crisis. Thus, these twin crises will accelerate in Europe in the second half of 2009 and 2010. In addition, the rate of contraction in European economies is already surpassing that in the US, and unemployment will be greater. I expect the focal point of the global financial crisis o gravitate towards Europe in late 2009 and early 2010. The inability of European institutions to effectively deal with the crisis may trigger political and social unrest not seen in many decades.

4. Disappointment from Asia.

In my view, the consensus regarding Asia and China in particular, is far too optimistic. Asia’s economies are far more dependent on exports to the US and Europe than most people understand. I expect many Asian economies to experience a dramatic collapse. In particular, despite massive stimulus efforts, growth in China will start going flat to negative by late 2009 and through 2010.

The Chinese are currently compensating for the collapse of the export sector through massive (and wasteful) public spending and completely irresponsible loan growth directed by the government. While the Chinese can certainly sustain this level of fiscal stimulus and bank lending for a while, they will not be able to grow it from current levels. In the absence of a recovery in the export sector – unlikely given my outlook for Europe above – this implies flat growth in 2010.

In addition, there is a wildcard: The effects that internal migration trends will have on the country. For the past 30 years a main driver of growth in China has been the incorporation of labor from the countryside. Most of this production was either zero productivity or was not even part of the cash economy (i.e. the production was not captured in GDP accounts). The export sector collapse has halted and even reversed this secular trend. This is a hugely important development that few if any analysts have understood, much less incorporated into GDP forecasts.

5. Commodity collapse.

Many folks are still waxing lyrical about “peak oil.” And there is much speculative chatter about buying commodities generally as a hedge against inflation. These speculations have fueled massive run ups in various commodities via ETFs which have inflated prices to current levels. Economic disappointments in Europe and Asia will soon prove such speculations to be untimely and will cause sentiment on commodities to reverse. This will trigger a dramatic unwind of these structurally unsound markets in which activity by legitimate commercial actors is being overwhelmed by financial speculators. I expect crude oil to revisit the 30s and perhaps even the 20s. Other commodities such as copper, which the Chinese have propped up through stockpiling, will also collapse back towards 2008 lows.

6. Emerging-markets crisis.

Most emerging markets outside Asia are highly dependent on commodity exports. The Russian economy will be devastated by lower oil prices. Ditto for nations such as Venezuela and Mexico. Brazil will be tremendously affected by the decline of various agricultural and industrial materials commodities. Emerging markets are also highly dependent on investment and remittance flows. After a brief dawn in mid 2009, these external factors should once again become a major drag on emerging economies in late 2009 and early 2010.

7.Valuations.

Amateurish articles were being published in the financial press proclaiming that based on current earnings, fair value for the S&P 500 was 600, 500, 400, or even 300. These articles seemed blithely ignorant of the concept of normalized earnings or of the idea that current equity values must discount the net present value of all cash flows into the indefinite future -- not the cash flows of any particular year or years. History has shown that when valuations reach such extreme lows, the probabilities of upside appreciation are quite favorable.

This countertrend rally since March has brought valuations within parameters that are still low, but which are at least near levels that can be considered normal. It can be empirically shown that with valuations at current levels, odds for current upside or downside are close to even. As such, valuation no longer provides a support for the market.

Psychological Factors

8. Psychology.

Fundamentals are important. However, just as critical are 2 factors. First: Which fundamentals will market participants focus on? There's an overwhelming amount of data available, much of it contradictory. Which data market participants choose to focus on depends on their biases and their state of mind. Second: How will they interpret the data? The same data can be interpreted by reasonable people in different ways.

The psychology that pervaded marginal market participants from late 2008 through early 2009 was one of “irrational despondence.” The doom and gloom got completely ridiculous. Pundits were proclaiming the collapse of the US dollar, the end of the American dream, deflation, hyperinflation, and much more sensationalist and even contradictory nonsense.

The nonsense got so out of hand, in fact, that people were calling for the nationalization of the US banking system -- a position driven by hysteria and an utter lack of understanding of the fundamentals of the US financial system At this time, the marginal market participant was seeing only the downside and completely ignoring potential upside. It was pretty clear that as soon as people realized that things were not as hopeless as they'd been led to believe -- and that there were viable short-, medium- and long-term solutions to the various problems afflicting the nation -- the market would rally strongly. The problem is that after 3 months of psychological relief, better-than-expected news seems to have become old hat.

And the old bearish bugaboo tales of deficits, debt, money growth, etc. seem to be coming back in style. The mood has shifted from one of surprise (that things weren't as bad as expected), to one in which people are focusing once again on the fact that it's “still bad.” In this context, folks are looking for reasons why things are bad -- and this causes them to gravitate towards bearish explanations and ways of looking at the world.

Put it together: Worse-than-expected news and a prevalent psychology that seems to be looking for bad news. It's a recipe for lower asset prices.

Technical Factors

9. Exhaustion.

Many market participants bought into this market at levels at or around 920-950. After the major scare that took markets to 870, many of these Johnny-come-lately traders and investors will be relieved at the opportunity to bail out at break-even levels. Today, after a substantial scare and the shift in psychology, the 950 resistance looms much more formidable than it did a few weeks ago, and the market is likely to exhaust itself at or around this level.

I see one major risk to this technical and psychological outlook: Almost nobody seems to believe that the S&P 500 can rally significantly beyond 950. Indeed, various sentiment indicators are flashing levels of pessimism not seen since March of 2009. And cash levels remain extremely high.

This could conceivably lead to a short-squeeze type of situation. Ultimately, though, such a move up -- if it were to occur -- will be doomed. In the end, it's far more important that the flow of fundamental data will be turning from marginally positive to marginally negative.

Moreover, at the local scene, the FBM KLCI seems to look tired as it is exhausting itself around 1120s with decelerating momentum. As the new moon looms on Tuesday, a reversal from here could see a near-term 25% or 38% retracement of the rally started since March09.

I see US markets languishing, probably trying to find a range somewhere between recent highs and the March lows. Perhaps that range could be somewhere between 750 to 850, with short forays outside such a range. Technology stocks should outperform in a big way while energy- and commodity-oriented stocks should suffer steep declines. Sector and stocks selection will be the name of the game in the second half of 2009 and 2010.

The best opportunities to make money may be on the short side in Europe, Asia, and emerging nations -- for those that know how to navigate these markets. The currencies and equities in these markets are little understood -- particularly in the US -- and their prospects are vastly overrated.