With trading in May finished, we can look back at the month in its entirety and definitively say the old market adage,?Sell in May and Go Away? was wrong as could be. The month of May was the third straight month of positive returns in the U.S. equity indexes, the first such streak since August through October of 2007. The S&P 500 finished more than 5% higher for the month, in comparison to the 9.4% gain in April and the 8.5% gain in March. The rally in equities has indeed been impressive as the S&P is up more than 25% in the past three months, and an amazing 38% from the low point in early March.

It was not just stocks that enjoyed May, but crude oil also posted a huge 29% gain in May, its largest one month gain since 1999. The price of crude finished the month just shy of $67 per barrel, even as OPEC decided that no further supply cuts were necessary. Oil was not alone either as in general commodities were all propelled higher by the devaluation of the dollar. The basic materials index (IYM ) gained close to 14% on the month, which outpaced even gold, the traditional hedge against inflation as SPDR Gold Trust (GLD) was up about 10%. The combination of the dollar?s rapid decline and the prospect of economic growth on the horizon has propelled commodities to rebound quite strongly.

The question now is what to expect for the summer months ahead. At Ockham, we are not market timers and think that it is foolish for anyone to claim they know where the market is headed in the short term. However, here are some observations that we think may be important to keep in mind over the coming months.

The stock market is no longer cheap. An argument could?ve been made that the market was cheap in Feburary, March, and April, but it is increasingly hard to justify any longer. Remember, this is very different than saying the market is headed down, but we believe that the gains of the past few months are still vulnerable. According to Barron?s online, the S&P 500 is far more expensive than it was a year ago according to a standard price-earnings ratio. A year ago when the S&P 500 was in the high 1300?s the P/E ratio was about 22x, but given the massive declines in corporate earnings expectations Barron?s pegs the P/E at 123x! These numbers are as of May 25th so next week could go either way but you get the gist.

Our internal calculation of the S&P 500 valuation is not quite as extreme as Barrons, but it is hovering at about 46 times current earnings. Obviously, our earnings expectations have not fallen quite as far as Barron?s, but according to our estimates we are seeing earnings that have declined 79% since the peak in 2007 and 72% from one year ago.

The fundamentals of equities have not improved in the last few months enough to justify these gains, in fact most indicators have not improved much at all but the perception is that the worst is behind us and growth will ensue. That may be the case, and we certainly hope it is, but it demonstrates to us that the market is currently trading on emotion and psychology rather than based on fundamental improvements. Investor sentiment and consumer confidence have both improved markedly over the past three months. The hope of better days ahead has been a powerful driver and could continue until corporate earnings truly do start to rebound. However, if the economy hits a bump and fear, uncertainty, and doubt start to creep back into the picture the recent market rally could very easily turn to dust because it was built on sentiment and not fundamentals.

Both sentiment and fundamentals are a completely legitimate and necessary components to market action, but in comparison to fundamentals, sentiment can be extremely fickle. How long can ?better than expected? be enough to carry the recent gains in the equity indexes? We are of the opinion that the current rally has been largely devoid of fundamental improvement, which makes it all the more vulnerable. At Ockham, we quote Ben Graham often, and this seems a very appropriate time to reference his *Security Analysis*: ?Stock markets behave like a voting machine in the short term, while in the long term they act like a weighing machine.?

May 21st 2009

The feedback loops that sustained the bull market can work in reverse to devastating effect

BULL markets are about more than just rising prices. They create their own momentum, not to mention their own intellectual rationale (remember the “new era” talk of the late 1990s). When bull markets stop, those effects tend very quickly to go into reverse. The greater the excesses of the boom, the longer and deeper the reaction is likely to be.

The best known of these feedback loops is the use of borrowed money to buy assets. Rising prices make banks more willing to lend, creating more demand for the assets in question, pushing up prices even further and thereby appearing to ratify the original lending decisions of the banks. When markets fall this leverage works the other way, as could be seen when investors offloaded assets at fire-sale prices last year.

There are many other positive-feedback processes. Take share buy-backs, for instance. Companies used their cash (or borrowed money) to reduce their share capital. Markets might have treated this as evidence of a lack of imagination, or a paucity of profitable projects. Instead, they saw it as evidence that the managers were focusing on “shareholder value” and boosting earnings per share, however ephemeral that might have been.

By shrinking the supply of shares in the market, the buy-back splurge played its own part in prolonging the bull market. In America, Smithers & Co, a consultancy, says that net corporate buying of shares peaked at an annualised rate of around $1 trillion in late 2007. Companies were buying far more of their own shares than anyone else did. But the buying spree was unsustainable. Smithers calculates that American-owned companies were paying out some 70% of their profits at the peak, if you include dividends and buy-backs. They have since slashed dividends and will have to start issuing shares as well. Instead of borrowing money to pay back shareholders, companies now need to raise equity to pay back creditors.

The shift in the supply-demand balance is not confined to America. European companies have already raised a total of EURO56 billion ($76 billion) in rights issues this year, according to dealReporter, an information service. Robert Buckland, a strategist at Citigroup, says that British equity supply was shrinking at 4% per annum in early 2008, and is now growing by a similar amount. That is all down to financial companies, which have had to raise capital to repair their balance-sheets; net issuance from the rest of the market is basically flat.

The recent stockmarket rally has undoubtedly helped companies successfully issue shares. But it will also tempt more businesses to sell equities, putting a potential cap on the rally. As Mr Buckland puts it: “Equity issuance soaks up money that might otherwise have been used to drive the market higher.”

Another positive-feedback loop in bull markets used to be the final-salary pension fund. As share prices rose, pension schemes would move into surplus, allowing sponsoring companies to enjoy contribution holidays. That boosted both their cashflow and their profits, giving a further uplift to share prices. American companies could include an “expected return” from pension assets in their income statements, a return that drifted higher over the life of the bull market.

But a dismal decade for equities and low bond yields have now sent many companies into deficit. In Britain, under the fairly conservative assumptions used by the Pension Protection Fund, private-sector schemes had a deficit of GBP188 billion ($277 billion) in April. Having an exposure to a final-salary pension scheme is now a drag on a company’s share price, not a boon. BT, for example, is almost having to double its annual pensions contribution to GBP525m, a move that helped prompt a 59% decline in the British telecoms giant’s annual dividend.

Tax and regulation also work in a buoyant market’s favour. Booms tend to bolster tax revenues and make the government appreciate the virtues of the finance industry; cities compete to attract banks and asset managers by offering tax advantages and minimal regulation. When the bust comes, taxes rise and regulations are tightened. Activity slows and investment is discouraged.

All these effects can take many years to gain momentum, and help explain why bull markets can last much longer than observers expect. By the same token, however, when these processes go into reverse, they can also be self-perpetuating. And that is why there will have to be a lot more evidence than a couple of months of rising share prices before one can say that a new bull market is under way.

AN ARTICLE FOR YOU, FROM ECONOMIST.COM –