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.