Trouble in Muni Land

Municipal bonds began to have trouble a couple of weeks ago because of problems in the auction rate securities market. But in recent days, muni bonds have fallen off a cliff. The S&P National Municipal Bond Index consisted of 3,069 US muni bonds as of last September, and it attempts to measure the performance of the muni bond market. Last year, iShares created an ETF that tracks this index (MUB), and as shown below, the price has dropped dramatically in recent days. Looking around the media space, there hasn't been much talk of these declines yet, but rest assured that quite a few investors are taking hits on their portfolios due to these declines. Today's current decline of 1.53% would be the biggest one-day decline in the ETF's history.

10-Year Yield and Stocks

Generally speaking, low interest rates are interpreted as a good environment for stocks. However, over the last six months, the opposite trend has been in place. When interest rates rise, stocks have been going up, and when interest rates fall stocks have declined. The top chart below is a reprint of a chart we highlighted yesterday which shows the yield on the ten-year US Treasury since June. Over this period, interest rates have been in a downtrend, with three periods where yields rallied to the downtrend before resuming their path lower.

In the second chart, we show the S&P 500 over the same period. The sections of the chart in red highlight the three periods where interest rates rallied. As shown, during each increase in rates, the S&P 500 rallied (although each successive rally has had less and less strength). This current dynamic between stocks and bonds is likely to continue as long as credit markets remain on alert. As credit fears increase, Treasury bonds are likely to rally causing yields to fall while stocks decline. Then, when credit issues abate, investors are likely to rotate out of bonds and into stocks.

Making Money in the Amazon

Posted by David Gaffen

Annelena Lobb has this report on the new king of emerging markets.

Brazil edged past China to become the largest emerging market in the world, as measured by Morgan Stanley Capital International’s emerging markets index. Brazil has a free-float market capitalization of $509.10 billion and comprises 14.95% of the index; China, $481.80 billion and 14.15%, respectively, according to MSCI, FactSet and Citi Investment Research.

Brazil has enjoyed a “meteoric” rise since mid-2007, said Geoff Dennis, Citi’s Latin America equity strategist; a report he wrote for Citi notes the role of market juggernauts like state-oil concern Petrobras in Brazil’s surge. Petrobras shares have rocketed over the last 12 months on the price of oil, as well as the discovery of the Tupi oil and gas field, 180 miles off the coast of Rio.

Chinese equities markets have also corrected lately, he notes, helping Brazil move into first place. Longer-term, Mr. Dennis notes that Brazil has risen relatively steadily since its trough in mid-2002, when it made up 5.3% of the MSCI index, and the two biggest fish were Korea, now third, and Taiwan, now fourth.

But they’ve underperformed and Brazil, a big exporter of commodities, has outperformed — Korea, Taiwan and China are all net commodities importers. “It all comes back to commodities,” he said.

In the near future, the run-up in Brazil probably leaves it vulnerable to profit-taking; Brazilian interest rates may also rise, Mr. Dennis said. Longer-term, oil, mining and other commodities will continue to boost Brazilian markets, he said, assuming any U.S. recession isn’t too painful. As for China, when its market is “less frothy,” it will “come roaring back – but I wouldn’t expect China to go racing past Brazil anytime soon.”

MKT RMR - BANK OF AMER FOR UBS - NOT CONFIRMED

Mortgage Rates and Housing

Back in January as mortgage rates ticked lower by the day, the outlook for housing began to look better. Lower rates obviously mean lower monthly payments, giving potential home buyers more of an incentive to actually pull the trigger on a purchase. Part of the reason the Fed is cutting rates is to get mortgage rates down in order to spur buying activity and more refis in the real estate market.

Unfortunately, since mid-January, even in the face of large rate cuts by the Fed, mortgage rates have spiked sharply. As shown in the chart below, the average 30-year fixed mortgage rate has risen from a low of 5.25% on January 23rd to its current rate of 5.82% as of yesterday (they've ticked even higher today).

Just a couple of weeks ago, we spoke with some real estate and mortgage agents and heard positive news on the market. Lower rates had in fact had an impact on buyers, and activity had started to pick up again. That mood has since changed as some buyers are backing off.

Large and Globalized

In our last post, we highlighted the best and worst performing Russell 3,000 stocks since the market peaked on October 9th. We broke the stocks into deciles based on their market caps to see how companies have performed based on their size. As shown below, the decile of stocks in the index with the largest market caps is down just 10.93% since 10/9, while the decile of the smallest stocks is down the most at -19.96%. As markets decline, investors definitely gravitate more towards the established large cap names.

We also took the stocks in the Bespoke International Revenues Database to see how stocks have performed based on the amount of sales they receive outside of the US. Many investors are looking for companies with large global exposure as sales in the US slow. As shown below, the stocks with more than 50% of revenues coming from outside of the US have held up better than stocks with no international revenue exposure since the market peaked. For investors that want to find the stocks with the most or least amount of international revenue exposure, the database is available to all yearly Bespoke Premium subscribers.

Half Up, Half Down -- Real Estate in Q4 '07

For those interested, the National Association of Realtors released their Q4 '07 home price survey today. The report showed that half (73 out of 150) of the cities analyzed showed increases in year over year prices in the fourth quarter. Below we provide a table of the cities that saw the biggest gains and declines in home prices. On a regional basis, the West saw the biggest declines at -8.7%, while the Midwest saw the smallest declines at -3.2%. Overall, home prices in the US declined by 5.8% in Q4 '07 versus a year ago. Please click here to view a PDF of the prices for all 150 cities.

Auction-Bond Failures Roil Munis, Pushing Rates Up

By Martin Z. Braun

Feb. 13 (Bloomberg) -- Bonds sold by U.S. municipal borrowers with rates set through periodic auctions failed to attract enough buyers as banks including Goldman Sachs Group Inc. and Citigroup Inc. that run the bidding won't commit their own capital to the debt.

Rates on $100 million of bonds sold by the Port Authority of New York and New Jersey, with bidding run by Goldman, soared to 20 percent yesterday from 4.3 percent a week ago, according to data compiled by Bloomberg. Presbyterian Healthcare in Albuquerque and New York state's Metropolitan Transportation Authority also experienced failures, officials said.

What began three weeks ago with too few bidders for auction-rate debt backed by relatively small entities, such as Georgetown University and Nevada Power, has widened in recent days to include large issues of state governments, such as New York state's Dormitory Authority. The auction failures provide new indication of Wall Street's unwillingness to commit capital amid $133 billion in credit losses and asset writedowns.

``It's the beginning of the end for the auction-rate market,'' said Matt Fabian, a senior analyst with Concord, Massachusetts-based Municipal Market Advisors. ``Banks have stopped supporting the market.''

Investor demand for the securities has declined on waning confidence in the credit strength of insurers backing the debt, and on reluctance by banks to submit bids and risk ending up with too many of the bonds. Local governments that have borrowed in the $300 billion auction-rate market confront the prospect of higher borrowing costs as economic slowing trims tax revenue.

Auction-Rate Bidding

Auction bonds have interest rates that are determined by bidding that typically occurs every seven, 28 or 35 days. When there aren't enough buyers, the auction fails and bondholders who wanted to sell are left holding the securities. Rates at failed auctions are set at a level spelled out in official statements issued at the initial bond sale.

Other borrowers paid higher rates, even if their auctions didn't fail. Wisconsin's 28-day auction yesterday of taxable bonds was set at a 10 percent rate, up from 4.75 percent for identical securities Feb. 7.

Frank Hoadley, Wisconsin's director of capital finance, said he had no advance warning from bankers about the jump in rates. ``We are making decisions'' about converting the auction bonds to different kinds of debt, he said.

Vermont Student Loans

Yesterday, $27.5 million of federally taxable student loan debt issued by Vermont's Student Assistance Corp. and insured by Ambac Financial Group Inc. reset at 18 percent, up from 5 percent as of Jan. 15. Ambac was the first bond insurer to lose its AAA credit rating.

Local governments are obliged to pay the high rates until either the auctions start attracting more buyers or they modify the bonds to some other kind of variable-rate debt or a fixed interest rate. Bankers and borrowers have been working on conversion plans for several weeks.

The 20 percent rate for the $100 million of Port Authority auction bonds will cost it $388,889 until the next weekly auction, up from $83,611 last week. Interest on the bonds is subject to federal income tax.

``We have seen widening spreads, reduced demand for certain auction-rate securities and failed auctions, including some auctions in which Citi acted as broker dealer,'' Danielle Romero-Apsilos, a spokeswoman at New York-based Citigroup, said in a statement.

Dormitory Authority

A Citibank-run auction for the New York state's Dormitory Authority failed yesterday, resulting in an interest rate of 6.26 percent, up from 3.12 percent a week earlier, according to Bloomberg data. Following the auction miss, the interest rate was set at twice one-month Libor, the London interbank offered rate for wholesale bank deposits, according to the official statement for the bonds.

Michael DuVally, a spokesman at New York-based Goldman, declined to comment.

The turmoil in the auction-rate market is the latest fallout in a credit squeeze that began with the subprime mortgage market collapse last year.

Bidding by dealers is essential to the smooth functioning of auction securities and banks are now wary of loading their balance sheets with the bonds, said Alex Roever, a JPMorgan Chase & Co. fixed income analyst.

`Tremendous Stress'

``This market has been under a tremendous amount of stress,'' Roever said. ``Without the dealers providing an active secondary bid, it's very hard for these transactions to clear.''

The soured auctions in recent weeks are the first since September, when about $6 billion of auction debt failed on investor concerns that bond insurers may lose their AAA ratings, Roever said in a Feb. 8 report. The latest wave began as recently as Jan. 22, when auctions run by Lehman Brothers Holdings Inc. for Georgetown University and Nevada Power failed.

Presbyterian Healthcare in Albuquerque, operator of seven hospitals throughout New Mexico, had rates on $38.7 million of debt reset at 12 percent after an unsuccessful auction run by Goldman yesterday. Bob Davis, Presbyterian Healthcare's vice president for treasury services, confirmed the failure, declining further comment.

Unsuccessful auctions have hurt companies that bought those variable-rate securities as short-term investments with excess cash, and are unable to sell their holdings. Bristol-Myers Squibb Co., the New York-based maker of the anti-clotting pill Plavix, announced on Jan. 31 a $275 million writedown of its holdings, which totaled $811 million at the end of 2007.

About a third of 449 companies polled in a survey last May for the Association for Finance Professionals said they permitted investment in auction-rate bonds.

Not a Short-Covering Rally

The rally from the January lows to early February was due largely in part to short covering. With that in mind, we checked to see if today's rally was being led by the most heavily shorted stocks. Surprisingly, today's gains are being led by stocks that have the smallest amount of short interest as a percentage of float, while the most heavily shorted stocks are up the least. Either the shorts are holding strong on their positions or they don't have nearly as much to cover as they did earlier in the month.

In the chart below, we broke up the Russell 1,000 into deciles (ten deciles of 100 stocks) based on short interest as a percentage of float. We then calculated the average percent change on the day of stocks in each decile. As shown, the decile of the most heavily shorted stocks is only up an average of 0.42%.

The Real Deal: Breaking the distressed debt deadlock

Would the real distressed debt funds please stand up?

It has been more than six months since the opportunists raced to raise “dislocation” funds in the hope of snapping up souring collateralised debt obligations and leveraged buy-out loans at a discount.

But so far, hardly any of that money has been put to work. The reason? It’s Catch 22. The banks don’t want to sell at substantial discounts and recognise losses, but these dislocation funds were raised to deliver high returns and need substantial discounts to par value from the banks.

Last year, the banks offered and received bids from these funds for unsyndicated loans in names such as First Data, or the mezzanine loans in Boots, at prices closer to 96, or 4 per cent below par.

Since then, these loans have traded 10 per cent or more below par - meaning buyers such as traditional high-yield hedge funds are also sitting on losses and become forced sellers, as they face margin calls and redemptions.

It must be very tempting to buy senior loans such as ProSieben at 73, when the return on buying could be more than the return its owners KKR and Permira achieve on the equity.

As prices approach the required yields these funds are targeting, their managers must ask themselves if they’re falling into a similar trap as those investors that bought loans closer to 96.

A distressed loan may look attractive at 90 cents if you believe it will return to par and deliver a target return of, say, 12 per cent.

But if these dislocation funds fear defaults, then the required discount may have to be steeper as it is not clear even senior secured loans will get back all their money in the event of default: 80 may be the new 90.

High-yield debt is illiquid at the best of times, it is not like trading Vodafone. Timing the point of market entry and exit is crucial.

But that is what these funds are paid to do, and must do, if they want to break the deadlock in the distressed debt market.

Time to go long subprime?

Bear Stearns has increased its subprime short positions to $1bn - up from $600m at the end of November.

While that might ordinarily seem like a conservative - if late - measure, it’s perhaps worrying in light of two other rumoured developments:

1. Goldman Sachs is apparently now, net, long subprime
2. JPMorgan is going long subprime

All very speculative, of course and possibly too good to be true. Hat tip to Dealbreaker - who pointed out the whole potential irony.

Two Bearish Covers in a Row

Last week we highlighted Business Week's cover story on the meltdown in housing. This week's issue follows up with the credit markets. While the efficacy of the magazine cover indicator as a contrarian signal is up for debate, covers like these (as well as this morning's Wall Street Journal headline) show that no one can accuse the press of being overly bullish on the prospects for the economy. If things do become as bad as most of the media is predicting, it will be the most widely predicted crash in history. And remember, these headlines are coming out after many financials and housing stocks have already corrected 50% or more.

Housing Futures Fall Through the Roof

While the homebuilder stocks have recently formed an uptrend on a large pickup in volume, the outlook for the actual real estate market in 2008 has cratered. The CME has housing futures that track the S&P/Case-Shiller Median Home Price indices. Over the last 3 months, investors have been sending the November 2008 contracts much lower. As shown in the charts and tables below, Los Angeles home prices are now expected to decline 16% from 11/07 to 11/08. The 11/08 contract for Los Angeles has fallen 15% over the last 3 months. The composite index of all 10 cities is expected to fall 10% from 11/07 to 11/08, down 7% over the last 3 months. There are a few cities not expected to fall too much though. Chicago and New York are expected to fall less than 5% by this November, and the New York 11/08 contract is actually up 2.32% over the last 3 months.

Expectations have clearly become very negative for housing this year. We wonder if 11/08 is the capitulation point?

A Crash or a Fender Bender?

The declines of the type that the market has seen over the last month have resulted in some commentators bringing the crash adjective off the shelf. While that may be too severe (at least for what's happening in the equity markets), we would note that the current decline off of the October 2007 highs is the fifth fastest decline of 15% or more from an all-time high in the S&P's history. Below we highlight each of the five periods as well as how the S&P 500 performed going forward.

Looking back at the past provides a mixed picture of what to expect over the coming months. As shown, while the periods covering 1929 and 1987 top the list, when they reached the 15% threshold they were still in free fall and hadn't yet 'crashed'. In the most recent two periods (1990 and 1998) however, once the 15% threshold was reached, the bulk of the declines were already over.

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Are Value Stocks A Good Value?

After growth stocks, and more specifically, the four horsemen of technology outperformed the market during 2007, some well regarded advisors think that 2008 may be the year for value stocks. In fact, one popular value investor thinks that at current levels, value stocks are trading at one of their steepest discounts to the overall market since 1970.

Richard Pzena runs Pzena Investment Management (PZN), and in his fourth quarter newsletter, he highlights that the only other times where value stocks were cheaper than they currently are was in November 1999 (Internet Bubble), June 1973 (Bear Market/Nifty Fifty), and October 1990 (S&L and Real Estate Crisis). In his example, Pzena classified value by looking at 100 stocks in the S&P 500 with the lowest price to book ratios. On a side note, it's somewhat ironic that according to Bloomberg, Pzena's publicly traded company trades at a price to book ratio of 101.91, which is 38 times the level of the S&P 500!

While many investors often measure a stock's value based on its P/E ratio, Pzena's use of book value is hardly out of the norm. In his book What Works on Wall Street, James O' Shaughnessy devotes an entire chapter to measuring the performance of stocks based on their book values. He points out that many investors believe it is "a more important ratio than price-to-earnings...since earnings can be easily manipulated by a clever chief financial officer." O'Shaughnessy's conclusion is that, "Over the long-term, the market rewards stocks with low price-to-book ratios and punishes those with high ones."

With Pzena's and O'Shaughnessy's findings in mind, we screened the S&P 500 for the 100 stocks with the lowest price-to-book ratios. However, given the recent writedowns in the financial sector, we wanted to avoid names that looked cheap but may face further writedowns in the coming quarters. For example, Ambac (ABK) and MBIA (MBI) both have some of the lowest price-to-book ratios in the S&P 500 (0.59 and 0.55, respectively), but over the last year ABK's book value has declined by 62% while MBI's has declined by 45%. In order to avoid these companies whose book values have been falling by almost as fast as their earnings, we further screened the list for companies whose book values have increased by at least 10% over the last year.

While the names in the above list may not be the sexiest stocks in the S&P 500, we would note that while the S&P 500 has had a total return of negative 9.5% year to date, the twenty names on the above list have outperformed, declining by 6.2%.

You have failed me for the last time, Auction Rate Municipals!

I've received several e-mails in the last couple days about municipal auction rate securities, after auction failures in both Nevada and Georgetown University. The e-mails ask three important questions.

1) What the hell is an auction rate security?
2) Why the hell are the auctions failing?
3) How much should we panic?

Well fortunately, its all pretty simple. When municipal issuers want to sell variable-rate debt, they normally do it one of two ways. One is called a Variable Rate Demand Note (VRDN), and the other is called an Auction Rate Security (ARS). Both work pretty similarly. I'll describe the auction bonds in detail because those are making news.

Auction rate securities usually have long-term maturities, 30-years or more. The rate is determined by auction, which is conducted by a broker/dealer firm, often called the "remarketing agent." The auctions occur at regular intervals, commonly every 28 days. Potential buyers give the dealer a rate at which they would buy some amount of the bonds. Current owners of the bonds can also put in a rate in which they'd sell, although typically those that want to sell just tell the dealer to sell at any rate. The seller gets par no matter where the rate is set. The rate is set at the lowest rate which clears the market.

ARS are sold to investors who want to take very little risk. While the auction process and the ability to sell bonds at par within a few weeks assures that interest rate risk is low, other means are needed to mitigate credit risk.

Most commonly, a bank is brought in to provide liquidity support. In general, the bank provides full credit support, assuming the issuer hasn't already defaulted. As a result of this, investors in ARS don't have to worry that the issuer will have enough cash on hand to handle sales of their bonds. As long as the issuer is current on its interest payments, the bank will provide cash for normal redemptions of bonds. Think of it like a line of credit.

Here is where things get a little weird. Sometimes the issuer of a ARS was a little more sketchy credit. The bank was only willing to provide liquidity if there was some additional credit support. No problem, thought the municipal bond bankers! We'll bring in a monoline insurer! The bank would therefore agree to provide liquidity so long as the bond insurer was rated at some minimal credit rating level. What that level is depends on the deal. Might be AA, might be A. I haven't seen any that were actually AAA but they could be out there.

But what happens if the unthinkable happens? A monoline insurer gets downgraded? Well, the bank's liquidity agreement becomes null and void. Where does that leave bond holders? It leaves them with no credit support at all. Only the issuer itself would remain.

For most ARS buyers, that's not acceptable. ARS buyers tend to be money-market like investors, who have zero desire to take on credit risk. So what are those bond holders doing? They are selling the bond back to the remarketing agent! See, while the insurers still have a AAA or even AA rating, the liquidity facility is probably still in force. So ARS owners know they can get out now. They don't know they'll be able to get out at the next auction, 28 days later.

Notice this problem would only apply to ARS with dual credit support. ARS with just a straight liquidity facility wouldn't have a provision relating to insurer downgrades, so there are no problems. So what might have seemed like an extra layer of support turns out to be a loaded gun pointed at your head. The phrase "That's no moon" comes to mind.

So clearly we have more sellers than buyers. Of course, such a situation can happen on any given auction period, where it just happens to be that more sellers show up than buyers by happenstance. In this situation, the remarketer would normally take the extra bonds onto its own books, figuring they can sell them to investors in the coming days.

But this is not a typical situation. Dealers are unusually capital constrained, making them less willing to take bonds onto their books. And the uncertainty of credit support makes it very difficult to sell the bonds, even at elevated interest rates.

The result? A failed auction. That simply means there weren't enough buyers to accommodate sellers, and therefore not all bonds offered for sale were sold. In such a case, the bond documents dictate some maximum interest rate at which the bonds reset. In the case of the Nevada Power deal which failed, the rate was 6.75%. Consider that is a tax-exempt rate, and would be something like 350bps over LIBOR. Non-problem ARS are currently yielding less than 3%.

Remember if you are a holder of this problem ARS paper, you may be stuck with your bonds for a little while, but you are getting paid a handsome yield on a bond where the ultimate credit (the issuer) isn't a problem. At least not right now.

Obviously for a bond issuer who is not having operational problems, having to pay an extra 3-4% on your bonds doesn't sit too well. So what can be done? Well, typically ARS are callable on any auction date, which means that issuers of this paper are going to refinance their debt (without Ambac insurance thank you very much) en masse in the coming months.

The big "so what" on all this? Well, it turns out to not be a very big deal. Issuers will wind up having to pay a fee to their investment banker to refinance the debt, but that's manageable. Some issuers may use this occasion to call their variable rate debt and sell fixed rate debt instead, given that interest rates are low. Assuming the debt is indeed refinanced, the ARS holders who are currently "stuck" will get taken out when the bonds are called.

You can decide for yourself how much you want to panic.

26 YEARS AND COUNTING...

There's been a lot of talk of bubbles lately, including speculation on where the next one lies. Some say it's in the energy sector; others claim that gold's a bubble. Here's our nomination: bonds.

Our proxy for fixed-income is the ever-popular 10-year Treasury, the benchmark for U.S. debt markets and in some cases foreign markets too. Exhibit A in our bubble thesis is the chart below, which shows the daily closing yield of the 10 year for 40 years-plus through last night's close. Restating the graphically obvious: the great decline in yield for the past 26 years. Since the peak of 15.84%, set on September 30, 1981, the 10-year Treasury's yield has, with fits and starts, become a shadow of its former self.

One Percent Moves Are More Common Than Uncommon

Typically, a daily move of one percent in the S&P 500 is considered a big up or down day. This year, however, moves of one percent or more have become the norm. Over the last twenty trading days, the S&P 500 has risen by at least one percent seven times and declined by more than one percent on eight occasions. This makes a total of fifteen one percent days over a twenty day period. In the chart below, we highlight prior occasions since 1990 where the S&P 500 had fifteen one percent days over a twenty trading day period. As shown, the volatility we have seen in the market is extremely uncommon.

Sector Earnings Growth in the Fourth Quarter

With earnings season more than halfway completed, below we highlight the actual year over year EPS growth numbers by sector. As shown, earnings in the Financial sector are down 120% from Q4 '06. The Consumer Discretionary sector is down 27%, and the Materials sector is down 5%. As a whole, earnings for the S&P 500 are down 24%. However, there are plenty of sectors that have showed strength, and when you strip out Financials, year-over-year earnings growth for the S&P 500 is actually 18%. Telecom earnings are up 57% and Technology earnings are up 31%.

We went back to the start of the fourth quarter to see what analysts were predicting for earnings back then. As shown, on October 4th, analysts were expecting Q4 earnings in the Financial sector to actually grow 2%. They were expecting Consumer Discretionary to grow 17% and the entire S&P 500 to grow 11%. While they got Financials, Consumer Discretionary and Materials wrong on the downside, they got plenty of sectors wrong on the upside as well. Energy earnings were only expected to grow 11%, and they are currently at 21%. Utilities were expected to grow 15%, and they are currently at 26%. Technology earnings are currently at 31% versus expectations of just 20% last October.

Looking at these numbers would probably lead an investor to believe that Tech, Energy, Utilities and Telecom would be performing great, while Financials and Consumer Discretionary would be doing terrible. However, it highlights the predictive mechanism of the market, because Financials and Consumer Discretionary tanked leading up to earnings season. Over the past few weeks, these beaten down sectors have performed great, indicating that investors are expecting earnings to turn around for them over the next few quarters. And even though Technology is doing great as far as Q4 earnings are concerned, the sector's recent poor price performance indicates future earnings will probably slow significantly.

A Short Covering Rally

From the 1/22 bottom through yesterday, the average stock in the S&P 500 was up 8.96%. We broke the index into deciles (50 stocks in each decile) based on each stock's short interest as a percentage of float and then calculated the average percent change of each decile from 1/22 to 2/4. As shown below, the decile of stocks with the highest short interest was up a whopping 17.1% from the bottom, while the decile of stocks with the lowest short interest was only up 5.3%. This analysis clearly highlights that the most recent gains have come from large amounts of short covering.

Draaisma: stand by for a bear market rally

Even when things are glum, Morgan Stanley former super-bull Teun Draaisma is unreformed. In his latest note, the MS equities man is starting to grow weary of all that bearishness since November.

Strategically, says Draaisma, the dominant themes for the next 6-18 months will be recessionary:

…earnings recession, continued deleveraging, lower commodity prices & inflation, and more reflationary policy initiatives. In addition, we expect further fears about the global economic cycle as a result of the US recession. Therefore, the equity trades we favour on a 1-year view are large over small caps, defensive over cyclical earnings, and low over high leverage.

But - and here’s the bullish bit - in the short term, expect a bear market rally.

Because of very bearish sentiment, low valuations and aggressive reflationary efforts we believe the stage is set for a traditional bear market rally. These are not for everyone, of course, and the danger is that if you buy into it you don’t get out in time. That is why we play this mostly through our tactical asset allocation, although we have also bought Swiss Re, Kingfisher, British Land and William Hill around mid-January on this theme. The main message is: don’t get too bearish now and cover some of your shorts, we expect there to be a better opportunity to become more pessimistic again in the next few months. And, if we are right that markets will be flat but volatile for the next 1-2 years, then tactical asset allocation can be a major source of performance.

But what’s also interesting, according to Draaisma, is that even with a recessionary trend in the long-term, we might already have seen the index-lows:

In the Earnings Recession Guidebook we showed what the typical bear market looks like. Earnings go down by 40% over 20 months, while the index goes down by 33%. We observed that equities peak about 1 year before earnings peak, on average, and trough some 2 months before earnings trough, as the end of the bear market is anticipated only with a small lead, thus underlining our rule of patience during bear markets. The more surprising conclusion is that there typically is a large bear market rally that starts around the time that earnings peak - which is about now - on the basis of hope on successful reflationary policy action, followed by flat but volatile markets that trough out towards the end of the earnings recession. The most surprising finding is that this first trough ahead of the bear market rally is typically the low point of that bear market (to be re-tested later on, but not broken). This suggests that we are making that low in Q1 of 2008. This is also backed up by our market timing indicators, where our CVI valuation indicator, for instance, is at levels showing good risk-reward for equities on a 6 month view, while sentiment indicators are as bearish as can be.

Or in stick-graph terms:

So the prognosis in the short-term? Looking at bear market rallies of the past as a yardstick - as the above indicates - we’re looking at a median bounce of 21 per cent over 4 months.

Roll on Spring.