What You Can Learn from the Greatest Rally Ever

The Great Reflation has begun.

All of the massive fiscal and monetary stimuli start to hit the markets. They’re starting to hit the economy too, although to a much lesser extent. And the bulls are off and running. It’s the Great Reflation.

During times like these, investors who are willing to set aside rising unemployment, problematic bank balance sheets, mortgage problems, unintended consequences of government regulation, etc. and take what the market gives them will do exceptionally well for the next few months – possibly through the end of the year.

We’re not the only ones seeing it though. One of the world’s greatest investors is on board too.

In the next few moments we’ll go through it all. We’ll look into why the market still hasn’t run too far too fast. We’ll look into how the market could climb another 30% from here. Most importantly though, we’ll try to identify the early warning signs to watch for to ensure we get out in time because, like all bear market rallies in the past, it will come to an end. And the end will come when everyone least expects it – which is likely a long ways off.

S&P 500 to Climb Another 30%!?!

Over the past few weeks we’ve focused on the different stages of bear market rallies, investor psychology, and how it will all play out over the next few months. After all, psychology is what is really driving the markets recently. Now, one of the world’s most successful and reasoned investors agrees.

Earlier this week Jeremy Grantham released his quarterly letter to shareholders (a must read for any investor: follow this link to access it). Grantham, whose name should be familiar to Prosperity Dispatch readers, manages $85 billion at Grantham, Mayo, Van Otterloo. He is one of the most devout students of stock market history. More importantly, he is one of the best at applying the lessons of history to portfolio management.

In short, Grantham is someone worth listening too. So a few days ago when he proposed the S&P 500 would continue its climb, it’s definitely worth delving into why.

To start at the beginning, Grantham wrote:

“My guess is that the S&P 500 is quite likely to run for a while, way beyond fair value (880 on our revised data), to the 1000-1100 level or so before the end of the year.”

Is he basing this on a full blown economic recovery – the rare “V-shaped” recovery? Will the catalyst be a surge in profits and cash flows for companies increasing the fair value of their shares? Or will it be strong growth from emerging markets leading us out of this?

Well, he’s not betting on any of them. He’s merely expecting history to rhyme.

The Greatest Stock Market Rally Ever

In his rationale for an extended rally he details what happened during the bear market of the 1930’s. The part which really stands out is one of the greatest bear market rallies in history. The rally was quick, strong, and unexpected.

Grantham stated:

In June 1932 market players saw illusory light at the end of the tunnel. In two months, the market rose almost vertically, climbing 110%!

For four more months it held the gain and then, confronted with continued unrelieved bad news, sank steadily for six months so that one year after the rally began it was up only 35%.

But this is the key: by then – a year later – there really was light at the end of the tunnel and the market rose again, 130% in eight months. And this time it did not give it back.

Think about that for a second. The market climbed 110% in two months. It makes what happened in the past two months look like nothing. The important part of that rally though, just like this one, is that it was fueled by expectations of a sharp and quick economic recovery.

Could it happen again and are we in the midst of it, you ask?

Well, circumstances are a bit different this time. But by identifying the differences we can get a good idea of how high this rally can really go.

For example, the key difference is what part of the bear market we’re in. The 110% rally in 1932 came after the market fell 90% from 1929 highs. That’s like a stock falling from $10 to $1 and then rallying back 110% from there to $2.10. It sounds like a lot at first, but it’s not much in the bigger picture.

That’s where the differences lie. This time around the markets were hitting lows about 55% off their highs. So that theoretical $10 stock would have fallen to $4.50. A 110% move would put it right back at $9.45 – just shy of its highs.

When dealing with the S&P 500, that is a bit too much to expect. But another 20% to 30% rise, to put the markets in line with Grantham’s S&P 500 call to top out at 1,000 to 1,100, is certainly possible – if not likely.

I know what you’re thinking, “Come on, another 30%. The markets are already up about 35% so far.”

It sounds unlikely, I know. But that first 35% would have seemed nearly impossible two months ago. It seems even less likely considering there are so many economic problems, uncertainty over earnings, and a slew of new government intervention across so many industries, but that’s not what matters here. The market is driven by psychology over the short-term and it all rolls into how the markets work.

Mr. Market’s Mysterious Ways

It’s no secret, the stock market is either one of the best ways to make a fortune or lose one. We can see in the disparity in the success had by different investors.

Most mutual fund managers consistently lag the markets over time. Meanwhile, a few investors seem to consistently outpace the markets over time (i.e. the Buffetts, Granthams, and Dremans of the world). Very few investors just do an average job.

That’s how the markets work. When stocks are up, people want to buy stocks. When they’re down, nobody wants them. Inevitably, most are doomed to fail.

Right now, we’re watching that cycle play out in a very protracted fashion. The current market rally has brought some money back into the market. As we’ve discussed before though, there is still a lot of money on the sidelines. And that has yet to come in as fast as it could (or, more likely, will). That’s why I expect that money to come into the markets in a slow and steady way over the summer and well into the fall.

Bear Market Rally: Stage 3

Over the past couple of weeks we’ve watched this bear market rally transition from Stage 2 into Stage 3.

Stage 2 is when most people say, “OK, the market is going up and I’ll dip my toes in the water.” They’ll put a little bit of money to work, but they won’t go in as deep as they would when everything looks just fine.

Stage 3 is when we see a lot more money come in. This is when the big money – mutual funds, institutional investors, etc. – start buying into the market and it appears all is well.

This happens because many money managers have customers who are watching the markets climb steadily and ask, “Why haven’t you gotten in on this?”

As a result, the managers are pressured to move into the markets in a big way. They have little choice. Either they deliver the returns their customers want or their customers will take their money elsewhere. Remember, they make money by managing money. The more money they manage, the more they get paid. So when the majority of their customers (the herd) want to be in the markets, they are forced to get in or lose the customer.

It’s not a great position to be in, but this is how the “Get in now, or you’ll miss everything” mentality spreads and creates the virtuous cycle of markets. The cycle starts with stocks going up. Then investors buy more because they don’t want to miss out. The markets go up more as more buyers buy in. And it goes on and on for a while.

In this situation, I don’t expect it too last too long though – maybe a year at best. But that doesn’t mean we can’t do well in between.

The Great Reflation Timeline

The current market rally is part of what we’ll call the Great Reflation. The combination of massive fiscal and monetary policy stimulus is making its way into the markets. It’s even having an impact in the economy too – although to a much lesser extent.

We’re seeing Bernanke’s “green shoots” and everyone is getting excited. The light at the end of the tunnel is visible and they don’t want to miss out. It’s all psychological. The fundamentals don’t matter much. We’re in the virtuous cycle and that’s what matters most.

Consider this. The recent market rally has sparked an increase in most everyone’s retirement and investment accounts (remember about 70% of Americans have some exposure to the equity markets).

Quite frankly, it’s a good feeling to see them go up as well and it causes people to change their behavior.

For example, armed with a “refound” paper wealth, consumers are starting to consume again. Businesses are starting to hire again to meet the demand. Unemployment is slowing and workers are feeling more confident in their jobs. They buy more and invest more which leads to more buying and investing and keeping the cycle going.

This virtuous cycle can go on for a long time. Of course, an economy takes time to correct which will be the eventual unwinding of this rally.

So far, most market forces have been allowed to work in the economy to a point. For instance, due to demographic and other forces, the economy must change. Demand for some products and services will decline and others will increase. This is the change we need and we’re starting to see it play out.

For instance, an extended drop in demand for cars will force a lot of car factories to shut down. The oversupply of houses will have to churn through at lower prices while very few new ones get built. The financial industry, which was a huge part of GDP, will contract as well. So far this year 11,500 stockbrokers left the financial industry. Many of those folks will have to find new jobs in new industries. Those are just a few industries though and there is a lot more to work through.

In the end, all of that change is going to take some time. And the current government support of many industries which must change will only make the transition last longer.

But we’re in the Great Reflation so most problems are covered up. It appears on the surface as an economic recovery. However, we know from history, this rally and the expectations of a noticeable recover are merely a false start.

So with that in mind, we’ll continue to be on the bullish side. We cannot, however, get too caught up in it all.

The companies, stocks, and people may change, but the stock market really doesn’t.

A sustained upturn in the markets will inevitably lead to great expectations (in a couple of months we’ll probably start seeing “Recession Over” headlines). It happened in 1932 and some people made a fortune.

As we’ve seen time and time again, great expectations almost always lead to even greater disappointments. And when the disappointments came, many of the fortunes made in the 1932 rally were inevitably lost.

By Andrew Mickey

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