The real thing?

No, I don’t mean Coke. I’m referring to the stock market rally, now 45 days old and not falling apart, despite considerable bad news and a pretty crummy earnings season. Could we finally be in the early stages of a new bull market, rather than one of those head-fake rallies that we most recently saw in late November to early January?

One of the characteristics of a new bull market is that most investors don’t recognize it until it is well underway. After a “normal” bear market, it typically takes an up move of 25–35% before the majority of investors realize that the lows are history. After this record-setting global collapse, one might expect investors to be even more cynical, requiring a 35–50% rally before most of them become believers. By then, of course, the easy money will have been made.

As this rally ages, and the lows and panic of early March fade further into the past, I continue to see signs that this one will stick. Little by little, several professional investors with excellent track records, and whose opinions I value, are saying that it’s becoming safer to buy stocks, and are putting their remaining cash to work. Some who were extremely bearish in March are turning bullish. At the same time, the vast majority of investors, both professionals and amateurs, are doubting the rally, keeping their funds in cash or bonds, and waiting for the market to drop 20% or more. They may have a very long wait.

Investor sentiment surveys are especially revealing. Two I follow are Investor’s Intelligence (a survey of investment newsletter writers) and the AAII Investment Survey (of individual investors). Both were extremely bearish in early March, with the AAII survey hitting a low not seen for at least 18 years. Since then, sentiment has understandably improved, but is still only slightly better than it was last fall, when the world seemed certain to end. In other words, most investors remain bearish despite a 25% jump in stock prices over just 6 weeks. This suggests that the “wall of worry” remains solid, which is a bullish sign.

The overall market is acting well, with virtually every sector participating in the recovery. More importantly, economically sensitive sectors, including technology, materials, industrials and consumer discretionary stocks, have been outperforming defensive sectors such as utilities, healthcare and consumer staples. This is an indication that some investors are looking forward to the economic recovery and are becoming more willing to take on risk. All of this bodes well for a continued financial and economic recovery.

This week was the first in 7 that stocks lost ground, but only a little. In fact, there has not been a drop of more than –5% since the rally began. This is typical of early bull markets, as investors with lots of cash wait in vain for that big pullback so that they can invest near the lows. But that big pullback rarely comes. Here’s an explanation from SITR Research:

“... at the start of a new bull market move, rarely will the market accommodate those investors [who are waiting for a big drop]. Our good friends at Ned Davis Research did a historical study of market pull backs at the start of new bull markets. The conclusion: the pull backs are small, typically way under double digits.

“The logic is simple; investors have hordes of cash by the end of a bear market cycle. Unfortunately most of that was raised right near the end of the bear market, which has to happen to make it the end—investor panic.... So, we have investors sitting with cash, saw the market rally, and wishing that they had invested some of their money near the low several weeks ago.

“They are now hoping for a pullback to put some of that cash to work. So when the pullback starts, there are always just a few who get anxious, and start nibbling and buying before the pullback gets very large. That little bit of buying attracts other buyers who had been sitting on the sidelines also, and the combination keeps the pullbacks small and shallow.”

Currently, we appear to be in a period of “consolidation,” when the major averages start trading in a relatively narrow range as individual stocks gyrate more wildly. Such periods can last several weeks or more, and are great times to put money into stocks and other “risky” investments. The market doesn’t run away from you, but at the same time, the movements of individual stocks relative to each other can enable one to take advantage of temporary pricing anomalies. The goal is to sell those stocks that become temporarily overvalued and buy those that are temporarily undervalued: an ideal time to rebalance portfolios. (I can’t promise the market won’t continue to rise strongly during the rebalancing process, but that’s still OK.)

Some of you have already received your new portfolio proposals, and the rest of you will over the next week or so. (Each portfolio is customized, so I can’t do them all at once.) I invite questions, both general and specific. I can’t know where you’re confused or disagree with me unless you tell me.

One additional point that I can’t emphasize enough: the financial markets always recover well before the economy. And the general public doesn’t start feeling good until many months, or even years, after the economy has bottomed. By the time Joe and Jane Main Street realize the recession is over, and the press prints mostly good news, half or even two-thirds of the bull market is already behind us. The prices of stocks and other assets are not rising now because things are good or even improving, but because the “smart money” can finally conceive of an end to this recession and financial crisis.