Paul Rabbitt Rabbitt Analytics .com
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Bear Market Rally Gaining Legitimacy

We are cautious due to the overbought condition but have edged into stocks. Our current allocation is 30% stock, 20% sector and country bull Exchange-Traded Funds (ETFs), 10% bear ETFs, and 40% cash.

We believe that stocks are in the process of affirming bottom. Stocks have experienced a buyer's stampede that began in the second week of March and is now 60 trading days old. With the consensus economic view focused on a deflationary cataclysmic economic cycle, aggressive action by central banks seemed to catch traction in stocks, reversed their declines and delivered a credible bear market rally. Additional short-covering has driven stocks into an extreme overbought condition.

Recovery Will Be Fragile
However, our enthusiasm is tempered and this time it is different. Recovery will be fragile. Recovery growth-rates will be restricted by rising taxes, interest rates, and energy costs over the next five years. While stocks are likely to be the more attractive assets over the next year or two, they will have to overcome widespread "battle fatigue". Investor preference for risk has shifted as they have seen their net worth halved in stocks and real estate. Consumers will not return to the spending spree of the previous half-decade as aging baby boomers seek to build retirement security and personal savings rates rise at the expense of consumption.

We Are in the Economic Trough
Investors are clearly looking across the economic valley, ignoring bad news, and anticipating a return to normalcy. We remind our readers that stocks discount the future by six months. The stock market is telling you the economy will emerge from recession sometime in October or November. A market environment where stocks "rise on bad news" is a characteristic of bull markets.

While the effectiveness of monetary easing and the treasury's plan dealing with "toxic assets" is not a foregone conclusion, it appears that downside risks have somewhat been reduced to both the economy and the equity stock markets. We believe the Fed and the administration have correctly assessed the financial crisis and switched from a reactive to a proactive policy. That view is even more supported now as the economy is delivering economic surprises including: existing and new home sales seem to be up ticking, durable goods orders are recovering, mortgage activity is increasing, and retail sales have been better than expected in two of the past three months.

Unemployment will continue to rise for the next 3 to 4 quarters. Leverage is being transferred from consumers, homeowners, and corporations to the US government. There's been a year-long global effort to reduce the manufacturing inventory that accumulated when worldwide demand fell a year ago. As the economy troughs and demand reawakens, inventories will be reduced to the point where manufacturing will be stimulated.

Headline Risk Waning
There has been a change in investor sentiment. The focus on damage-control is waning. The stock headline risk has declined appreciably. For example, stocks have risen while headlines discuss the impending probable bankruptcy of GM, the real bankruptcy of Chrysler, and the release of the Treasury Departments' bank "stress-test". This sort of news over the past year would have sent stocks tumbling lower.

Those who rode stocks down over the past 18 months are receiving some badly needed performance relief in March-April. Desperation to recover from severe portfolio losses over the past 18 months may drive these investors to take excessive risks. With 3 and 4 percent daily moves commonplace, we will err on the cautious side until things settle down a bit more.

Successful Companies Lagging the Market
In order to capture returns in the past six weeks, investors would have to abandon normal "success-factor" analysis. "Successful" companies are all lagging the market. These are companies with good earnings consistency, good earnings acceleration, strong price-momentum, positive consensus earnings estimate revisions, and positive earnings surprise.

Junk Leading - Similar to 2002
The profile of stocks currently leading the market is extremely high-risk. Stocks leading the rally include small and micro-cap and low-priced stocks with extremely high beta (volatility relative to Standard & Poor's 500). Clearly investors are seeking stocks that are best positioned to profit in an economic recovery. The simplest way to identify these companies is by looking for the ones that were hurt the most by the recession over the past year.

The result of this strategy is that, reminiscent of the leadership that occurred at the end of the bear market in 2002, investors are flowing capital into low quality, small cap companies with weak operations, marginal balance sheets, and marginal operations. However, we believe this strategy is fraught with heavier risks today than it had seven years ago.

Risk Has Shifted from Stocks to Bonds
Risk has shifted from stocks to bonds. Stocks historically are supposed to deliver higher returns than bonds. The reason investors demand higher returns is because stocks are higher risk instruments. Stocks have given back all the gains they achieved since 1996. Meanwhile, the long treasury index has returned 25%, excluding yield. In other words, the very investors who take on the additional risk to finance economic growth in our free enterprise system have received no return for the past nearly 1 1/2 decades. Clearly, the deflationary environment over the past year and commensurate bear market in US equities has inverted and widened the spread between stock and bond performance. Stocks are now the undervalued asset and bonds have fully discounted the deflationary scenario. We believe bond out-performance is an unsustainable trend.

Paul Rabbitt is an independent research analyst and portfolio manager. He is CEO of Rabbitt Capital, and chief portfolio manager of hedged and private capital. He is President RabbittAnalytics.com, delivering independent stock research to private and institutional clients since 1998 featuring the "Q" Stock Ranking system, a twelve-factor stock risk/return model ranking 2500 stocks daily, since 1989, with one of Wall Street’s best published track records.

Paul previously held dual roles as both Senior Portfolio Strategist and Chief Quantitative Analyst at CIBC Oppenheimer where he was an employee and partner for twenty years.

Institutional Investor Magazine has ranked Paul among the top eight quantitative strategists. He is a frequent commentator in the national and international media.