Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm mayhave a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.Refer to important disclosures on page 4 to 5.
10830182
Morning Call Notes
Reversible rally or reflexiverebound?
Either way, the test is the key.We are witnessing a reflexive rebound, in our view
What we are going to do today is provide some perspective on this impressiverally over the past five weeks. In our view, what we are witnessing, at best, is thefamed reflexive rebound that occurs between the down-legs of the secular bearmarket, as so eloquently referenced in Rule #8 of Bob Farrell’s Market Rules toRemember (it goes like this – “Bear markets have three phases: sharp down,reflexive rebound, and a long fundamental drawn-out decline”). By “reflexiverebound” what is meant is a real bear market rally that can last between four toeight months and have the capacity to rebound between 25% and 50%, asopposed to the countless flashy but not particularly tradable rallies that typicallylast four to eight weeks and post a 10% to 20% bounce.
The test remains the most appropriate near-term focus
So, the question is whether this is just a more intense version of the other spasmswe saw this cycle or something a little more durable like we had betweenSeptember 2001 and January 2002, when the Nasdaq surged 45%, but was re-testing the lows by June 2002 (and the test failed, as we know with hindsight), orperhaps something along the lines of the 43% bounce in the S&P 500 from 98 inMarch 1980 to 140 in November 1980. That low was tested by August 1982, aswe went through the ‘drawn out fundamental downtrend’, and, in this case, thetest was successful. But we had the retest nonetheless, and we think we have tobe reminded that the test remains the most appropriate focus over the near term.
Reflexive rebound vs. flashy bear market rally
What makes the reflexive rebound different than a flashy bear market rally is thatit’s not just short-covering and other buying on the part of the ‘pros’, but realmoney sitting on the sidelines that is put to work. This is why the reflexiverebound tends have more staying power. This is really a debate best left to thetechnical analysts, but for our two cents worth, history tells us that we have to becognizant of the re-test possibility. With the market up 28% and 85% of thestocks trading above their 200-day moving averages, the inevitable test issomething we should spend more time thinking about than trying to chase the lastleg of this rally, assuming it comes at all.
Economic Analysis
Economics | United States20 April 2009
David A. Rosenberg
+1 646 855 1389
North American EconomistMLPF&Sdavid_rosenberg@ml.com
Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm mayhave a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.Refer to important disclosures on page 4 to 5.
10830182
Morning Call Notes
Reversible rally or reflexiverebound?
Either way, the test is the key.We are witnessing a reflexive rebound, in our view
What we are going to do today is provide some perspective on this impressiverally over the past five weeks. In our view, what we are witnessing, at best, is thefamed reflexive rebound that occurs between the down-legs of the secular bearmarket, as so eloquently referenced in Rule #8 of Bob Farrell’s Market Rules toRemember (it goes like this – “Bear markets have three phases: sharp down,reflexive rebound, and a long fundamental drawn-out decline”). By “reflexiverebound” what is meant is a real bear market rally that can last between four toeight months and have the capacity to rebound between 25% and 50%, asopposed to the countless flashy but not particularly tradable rallies that typicallylast four to eight weeks and post a 10% to 20% bounce.
The test remains the most appropriate near-term focus
So, the question is whether this is just a more intense version of the other spasmswe saw this cycle or something a little more durable like we had betweenSeptember 2001 and January 2002, when the Nasdaq surged 45%, but was re-testing the lows by June 2002 (and the test failed, as we know with hindsight), orperhaps something along the lines of the 43% bounce in the S&P 500 from 98 inMarch 1980 to 140 in November 1980. That low was tested by August 1982, aswe went through the ‘drawn out fundamental downtrend’, and, in this case, thetest was successful. But we had the retest nonetheless, and we think we have tobe reminded that the test remains the most appropriate focus over the near term.
Reflexive rebound vs. flashy bear market rally
What makes the reflexive rebound different than a flashy bear market rally is thatit’s not just short-covering and other buying on the part of the ‘pros’, but realmoney sitting on the sidelines that is put to work. This is why the reflexiverebound tends have more staying power. This is really a debate best left to thetechnical analysts, but for our two cents worth, history tells us that we have to becognizant of the re-test possibility. With the market up 28% and 85% of thestocks trading above their 200-day moving averages, the inevitable test issomething we should spend more time thinking about than trying to chase the lastleg of this rally, assuming it comes at all.
Economic Analysis
Economics | United States20 April 2009
David A. Rosenberg
+1 646 855 1389
North American EconomistMLPF&Sdavid_rosenberg@ml.com
W
Morning Call Notes20 April 2009
2
Economic support for the rally has been dubious
Now, our purview is the economy, and all we can say to this is that the economicsupport for the rally to date has been a little dubious. And, as we’ve said in therecent past, there is a critical difference between improvement in the first andsecond derivatives. The latest negative readings in industrial production, housingstarts and retail sales should offer up some reason for pause over the expectationthat we have reached some sort of turning point in the recession. From a macrostandpoint, all we know is that nothing resembles the 1975, 1982, 1990 or 2002bottoms when bear markets ended on the cusp of a durable expansion ineconomic activity and corporate earnings. Bull markets initially start out asevents driven by technicals like sentiment and market positioning, but whatsustains them are the economic fundamentals, because that is what draws in thepublic, as opposed to only professional, support for equities.
Durable bull markets needs macroeconomic inflection point
No durable bull market has ever occurred without their being a macroeconomicinflection point within reasonable proximity of the market low. For example: thenational highway network in the 1950s, the space program in the ‘60s, and thespectacular household formation of the baby boomers and consumer balancesheet expansion that sharply bolstered domestic demand in mid-‘70s. The post-1982 bull market was driven by massive reductions in top marginal tax rates,deregulation and declining unionization rates. The 1990s was led by tech-induced productivity gains and rapidly diminishing fiscal deficits; and the last bullcycle from 2003 to 2007 was a function of leverage and a speculative debt-fueledplunge into residential real estate – ill-timed as it turned out.
What we have to look forward to
This time, as we gaze into the crystal ball, what we have to look forward to for theforeseeable future is an unprecedented incursion of government in the economyand capital markets, a much more regulated financial system, where thecontribution of credit to spending, output, employment and profits will be far lowerthan has been the case for the past two decades, higher environmental-relatedcosts, less free trade, rising union membership, and higher marginal tax rates topay for the fiscal mess we’re in. Most importantly, what we are looking at is asecular contraction in the household balance sheet as it relates to the babyboomer cohort – secular meaning many years. Keep in mind that it is this 78million US boomer population that has been the critical driver of global economicactivity, not to mention the pace-setter for consumer spending behavior – or lackthereof as the pendulum swings toward frugality.
Economic underpinnings not in place for a true bottom
Unless emerging markets in general or China in particular, can manage to pull thedeveloped world out its torpor, it is difficult to identify what the nextmacroeconomic underpinning is going to be that will generate a sustained bullmarket in equities. Sorry, but government sector expansion, hybrid cars, greentechnology and digitized medical records just don’t do it for us. While we arewilling to keep an open mind over the possibility that this reflexive rebound couldhave more legs, we simply do not have the economic underpinnings in place for atrue fundamental bottom, which is why we think, like Japan, the dominant themewill be the third part of Bob Farrell’s’ Rule #8, which is the drawn-out fundamentaldowntrend to the true low.
Morning Call Notes20 April 2009
2
Economic support for the rally has been dubious
Now, our purview is the economy, and all we can say to this is that the economicsupport for the rally to date has been a little dubious. And, as we’ve said in therecent past, there is a critical difference between improvement in the first andsecond derivatives. The latest negative readings in industrial production, housingstarts and retail sales should offer up some reason for pause over the expectationthat we have reached some sort of turning point in the recession. From a macrostandpoint, all we know is that nothing resembles the 1975, 1982, 1990 or 2002bottoms when bear markets ended on the cusp of a durable expansion ineconomic activity and corporate earnings. Bull markets initially start out asevents driven by technicals like sentiment and market positioning, but whatsustains them are the economic fundamentals, because that is what draws in thepublic, as opposed to only professional, support for equities.
Durable bull markets needs macroeconomic inflection point
No durable bull market has ever occurred without their being a macroeconomicinflection point within reasonable proximity of the market low. For example: thenational highway network in the 1950s, the space program in the ‘60s, and thespectacular household formation of the baby boomers and consumer balancesheet expansion that sharply bolstered domestic demand in mid-‘70s. The post-1982 bull market was driven by massive reductions in top marginal tax rates,deregulation and declining unionization rates. The 1990s was led by tech-induced productivity gains and rapidly diminishing fiscal deficits; and the last bullcycle from 2003 to 2007 was a function of leverage and a speculative debt-fueledplunge into residential real estate – ill-timed as it turned out.
What we have to look forward to
This time, as we gaze into the crystal ball, what we have to look forward to for theforeseeable future is an unprecedented incursion of government in the economyand capital markets, a much more regulated financial system, where thecontribution of credit to spending, output, employment and profits will be far lowerthan has been the case for the past two decades, higher environmental-relatedcosts, less free trade, rising union membership, and higher marginal tax rates topay for the fiscal mess we’re in. Most importantly, what we are looking at is asecular contraction in the household balance sheet as it relates to the babyboomer cohort – secular meaning many years. Keep in mind that it is this 78million US boomer population that has been the critical driver of global economicactivity, not to mention the pace-setter for consumer spending behavior – or lackthereof as the pendulum swings toward frugality.
Economic underpinnings not in place for a true bottom
Unless emerging markets in general or China in particular, can manage to pull thedeveloped world out its torpor, it is difficult to identify what the nextmacroeconomic underpinning is going to be that will generate a sustained bullmarket in equities. Sorry, but government sector expansion, hybrid cars, greentechnology and digitized medical records just don’t do it for us. While we arewilling to keep an open mind over the possibility that this reflexive rebound couldhave more legs, we simply do not have the economic underpinnings in place for atrue fundamental bottom, which is why we think, like Japan, the dominant themewill be the third part of Bob Farrell’s’ Rule #8, which is the drawn-out fundamentaldowntrend to the true low.
W
Morning Call Notes20 April 2009
3
It’s only the bottom of the fourth inning
To finish up, we have an old saying that, “when in doubt, use someone else’sresearch” and with that in mind, we point to a brilliant report by Ken Rogoff andCarmen Reinhart published late last year. This epic report examined 15 othercredit contractions and asset deflations in the past, and found that the bearmarkets in equities last an average of 3-1/2 years, with the bear market in houseprices lasting an average of roughly six years. So, when asked “what inning arewe in?”, the answer we’ve been giving, on this basis, is “the bottom of the fourth”.
Take advantage of the 50% increase in US Treasury yields
In other words, take advantage of the near-30% rally in equities by taking profitsand use the proceeds to take advantage of the near-50% increase in USTreasury yields since late last year.
Morning Call Notes20 April 2009
3
It’s only the bottom of the fourth inning
To finish up, we have an old saying that, “when in doubt, use someone else’sresearch” and with that in mind, we point to a brilliant report by Ken Rogoff andCarmen Reinhart published late last year. This epic report examined 15 othercredit contractions and asset deflations in the past, and found that the bearmarkets in equities last an average of 3-1/2 years, with the bear market in houseprices lasting an average of roughly six years. So, when asked “what inning arewe in?”, the answer we’ve been giving, on this basis, is “the bottom of the fourth”.
Take advantage of the 50% increase in US Treasury yields
In other words, take advantage of the near-30% rally in equities by taking profitsand use the proceeds to take advantage of the near-50% increase in USTreasury yields since late last year.
W
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