Bear market hibernates?

It moves like a bull. It looks like a bull. It even appears to be thinking like a bull. So is it a bull? Probably. But not definitely.

Yes, the bear appears to have gone into hibernation, but beware. It may just be dozing with one eye open. Bear market rallies can be very seductive. They can convince investors that the worst is over, suck them back in-and then clobber them!

Investors savaged
Want evidence? Just think back to this time last year.

• The Nasdaq tanked in early spring. In the shortened trading week after Easter, it dropped a breathtaking 25 per cent.
• By late May it had started a rally that carried it through most of the summer.
• Convinced that the high-tech wobble was over, investors poured money into what were seen as ‘cheap’ tech stocks.

When the bear market rally abruptly ended in the fall, the bloodletting was terrible. Prices of even the highest-quality tech stocks plunged to levels not pviously dreamed possible. Investors who had overweighted their portfolios to the sector in hopes of a repeat of 1998-99 were savaged.

Caution advised
That’s why I am cautious about fully committing to the herd that says the worst is over and we’re now poised for a new, long-term upward run.

• Yes, there are a lot of positive signs.
• Yes, all-important investor psychology appears to have turned around.
• Yes, institutional money managers are moving their cash reserves back into the market.

But there are still danger signals out there. To name a few:

• Nasdaq stocks are very expensive. Their prices may be way down, but so are earnings. As a result, the Nasdaq p/e ratio is even higher than it was when the index was riding high, somewhere in the vicinity of 200.

If earnings don’t improve dramatically, and quickly, the potential for another collapse is there.

• Inflation is picking up. It always disturbs me when a rising inflation rate is dismissed as no real cause for concern because the ‘core’ rate isn’t moving up as fast.

In Canada, the core rate does not include energy and food. The implication is that as long as we don’t eat, drive, or heat our homes, we needn’t worry about rising prices! The Bank of Canada issued a background paper May 18, which explains how it intends to redefine all this. About time!

• Long-term interest rates are rising. Alan Greenspan grabs the headlines with another half-point cut in the Federal Reserve Board’s key interest rate. Hooray! What is going almost unnoticed is the fact that longer-term rates are moving up, a signal that the bond market anticipates a turn in the rate pattern within a few months.

You can see the signs by looking at mortgage rates. May 17, Scotiabank announced it was decreasing all short-term rates, to one year, by 0.05 per cent to 0.1 per cent. But all longer-term mortgage rates increased, by as much as a quarter-point (0.25 per cent) for mortgage terms of four years and longer.

Rising long-term rates can be read as a positive sign in that they signal a belief by bond traders that the economy is going to pick up. But they are a negative sign in that higher long rates attract money to the bond market from stocks and are likely a precursor to a change in the Fed’s future direction. 

• The stock market advance is still quite narrow. For a full-fledged bull market to occur, we need to see a ‘rising tide lifts all boats’ pattern. We are not seeing that yet. This market is still very selective. If you’re not in the right stocks, you won’t do well.

Cautious optimism
The bottom line of all this is that I am cautiously optimistic that the cycle has turned, but I am not completely convinced just yet. If you’re sitting on a fair amount of cash, I recommend you gradually start feeding it back into the market, but keep some in reserve in case we experience another dip.

• Do not overload on tech stocks-something I have said before and repeat again.

That doesn’t mean you should avoid them entirely, but maintain a careful balance. Tech is still vulnerable, especially anything related to telecommunications.

There are excellent opportunities in other areas, so keep your perspective. Value stocks-those with low p/e ratios-are likely to continue to perform well in the coming months.

From the May 21 edition of the Internet Wealth Builder. http://www.gordonpape.com/newsletter/iwbnl.cfm