The bull keeps on running....

After last week’s –5% drop in the S&P 500, many were already calling an end to this rally. But I don’t think it’s over yet: far from it. This move up is likely to continue—with inevitable pauses such as the one last week—for many more months and even years. I suspect that before the new bull market is finally over, and stocks again suffer a –20% or greater decline, we’ll not only have reclaimed the highs of October 2007, but should be well beyond them. With very rare exceptions, bull markets are much bigger than the bears that precede them. The main risk to I see now isn’t losing money, but missing out on big profits.

Of course, I could be wrong. But I’m not seeing any economic or financial signs that disturb me. Most of the latter are hugely positive; for example, 3-month LIBOR (the rate at which many banks lend to each other) is now 0.78%. This is the lowest level ever, and it has fallen from 1.10% only one month ago. If LIBOR were to drop to about 0.50%, that would mean the inter-bank lending market was back to normal. It’s possible we could see this in just a couple of months.

Investor sentiment, while way better than it was in early March, remains tepid. And last week’s market drop was enough to convince many that the bear market is not yet over. As recently as last night, few expected a rally today. Tokyo was down –2.4%, as were several other Asian markets. But India changed all that when it rocketed +17% shortly after the open, apparently giving strong approval to the winning party in the just-completed election. Almost immediately, other Asian markets that were still open (Tokyo was closed) turned strongly positive, and the bull was reinvigorated. All this shows that markets can shift suddenly for little apparent reason.

Some of you are still waiting to see your re-allocated portfolios; most who have received them so far have had no comment (either you think they’re terrific or I’ve totally confused you). To all of you: don’t worry about missing the bull, we’ve got plenty of upside ahead of us. Just returning to the old highs on the S&P 500 would give us a +73% rise from here, and that’s without dividends. Allocating wisely among countries, industries and individual securities could provide even better results: non-US developed markets need to rise +87% (without dividends) to reclaim their 2007 highs, for example, and many individual stocks (such as GE) need to triple (that’s +200%) just to reach their old highs.

What’s driving the rally? There’s just too much cash out there, and cash isn’t earning squat. After inflation and taxes, nearly all so-called “risk free” investments are earning negative returns. If investors want to make a reasonable return in this environment, they simply have to take some risk. And in a nearly perfect reversal of the bear market, since their recent lows, riskier investments have provided higher returns than less risky ones. The risk-return relationship is again positive, as it has typically been over the long term.

Here’s a note from STIR Research on how institutional investors are dealing with their mounds of cash (written just before today’s big jump):

“According to this week’s Barron’s, growth stock managers have been left behind the last two months. Only 33% beat the benchmarks in March and only 25% in April. They want to catch up, and with high levels of cash, they are looking to buy on any dip.

“But the market has not been very accommodative. Last week we had 4 down days for the S&P 500, NASDAQ, the Russell 2000 and others. But on three of those down days volume was below normal. Even with Friday’s option expiration, which normally leads to a spike in volume, it was below average.

“We are interpreting that to mean, that even when the buyers pull back, sellers are not panicking and dumping stocks. Instead the selling has been drying up. Therefore, institutional investors wanting to deploy some of their excess cash, have to bid stocks higher to find willing sellers: a formula for a market moving higher.

“In a bullish report sent out Friday by Goldman Sachs, they noted that following the 18 largest bear markets in history, the initial rally lifts stocks 43% and lasts 180 days. And that is just the average.”

The last point is interesting. Given that the recent bear market was at least 50% worse than average, one could expect the initial rally to be roughly 50% stronger than average. This would imply that 6 months after its low, the S&P 500 would rise +65%, which translates into a level of 1,100 (compared to 910 today, or another +21% gain over the next 3 1/2 months). I’m not saying that this is what will happen, but it wouldn’t be out of line historically. Of course, if the global economy and credit markets are in decent shape by September, stocks should continue to move upward.

Remember that stocks are not the only “risky” asset. Corporate and municipal bonds, commodities, and real estate all fall into the risky asset category, and should also do well as the financial markets improve. They, too, deserve a place in most portfolios (and my model portfolios do include them). The only assets I would avoid right now are US Treasuries, CD’s and other “risk-free” assets. They should lag severely, and could even provide negative returns going forward.