No free lunches in debt-fuelled bear rally

Financial Times – David Rosenberg

There is no doubt that we have an incredible bear market rally on our hands. But after a monstrous 90 per cent rally from the March 2009 lows (over such a short time frame, and the most pronounced bounce since 1955) this market has become seriously overextended. While everyone focuses on the gross nominal returns, they do not see the risks that are nearly invisible to the naked eye. But we see the risks very clearly. Here at Gluskin Sheff & Associates, we assess them; we measure them, and we benchmark the returns against them.

I recall all too well that the 2003-07 bear market rally – yes, that is what it was.It was no 1949-1966 or 1982-2000 secular bull run. What drove that bear market rally was phony wealth generated by a non-productive asset called housing, alongside widespread financial engineering that triggered a wave of artificial paper profits.‪We have been patient and will remain so, with an eye towards maximising risk-adjusted returns. At the current time, we believe our clients are well served by our equity strategies (minimal cyclical exposure and a focus on an income equity-hard asset barbell); our long-short strategies (vital in controlling risk in the portfolio and underscoring our focus on capital preservation) and our fixed-income products (outside of commodities, deflation in the developed world remains the primary trend and it is in such a backdrop that “yield” makes perfect sense).‬ It goes without saying that as much as it hurts, not to be involved in a speculative rally that sees the market surge more than 90 per cent, it is much much tougher to actually experience a correction in the other direction. For the time being, it takes extreme courage and resolve not to jump on the bandwagon (“don’t fight the Fed”) and buy “the market” at current expensive pricing points.‬

As far as equities are concerned, make no mistake, we are in the throes of an intense bear market rally, which is likely at the very late stage. Bear market rallies are not the same as secular bull markets — the former are to be rented, the latter are to be owned. This is not the 1949-66 secular bull market that was underpinned by troops coming home and spurring on a baby-boom that would unleash years of tremendously strong domestic demand growth. The demographics in the US are now downright poor — just look at the ratio of the working age population to the total population. Nor is this the 1982-2000 secular bull market that saw the central bank usher in years of disinflation (the current one is trying desperately to create inflation) and a wave of innovation that saw not just the mainframe, the personal computer, the internet, and then the smartphone, but also a boom in the capital stock that enhanced structural productivity growth and led to sustained gains in private sector economic activity. By the end of that secular bull run, these gains allowed the government to actually start to record budgetary surpluses. What is the major innovation today? The iPod? The iPad? Facebook? These may be fun, but they don’t do much to promote the growth rate in the nation’s capital stock or productivity.‬ What we have on our hands has been an economic revival and market bounce back premised on unprecedented monetary and fiscal stimulus. How the Federal Reserve and the federal government in the future manage to redress their pregnant balance sheets without creating a major disturbance for the overall economy is a legitimate question and, sorry, does not deserve a double-digit market multiple.‬

The best buying opportunities for investors who have time horizons of more than five or even 15 months for that matter – those investors who are more focused on building wealth for the long-term as opposed to trying to make recurring short-term trading profits – will happen when we see the payback period. And this could happen sooner than you think. Do not assume that Ben Bernanke, chairman of the Federal Reserve, has any more rabbits in his hat or that the new Congress is going to fill anyone’s stockings with more fiscal goodies towards the end of the year.‬ Just as the 2003-07 bear market rally was built on a shaky foundation of unsustainable credit growth and house price appreciation, the current bear market rally has been built on the even shakier ground of surreal public sector intervention. Many believe this intervention “saved the system” or “prevented a depression” back in the opening months of 2009. The reality, however, is that there is no such thing as a free lunch.

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