But valuations have a tendency to overshoot on the downside during bear markets. As economist Andrew Smithers notes, Shiller’s cyclically adjusted price-earnings ratio bottomed out an average 50% below fair value during the six major bear markets from 1920 to 1982.

The unadjusted price-earnings ratio tells a similar story. It got down to a low of 7 in the bear markets of 1973 and 1982. Applying this valuation to strategists’ projected 2009 earnings-per-share of $70 for the S&P 500, the market would need to decline by more than a third from where it is now.

If the current recession is more of the common garden variety, valuations are not likely to overshoot as much. Over the past 14 recessions, the trough in the cyclically adjusted price-earnings ratio averaged 11, which would imply a drop of nearly a quarter from current levels . Of course, an overshoot is not necessarily inevitable. Indeed, Shiller’s ratio remained well above fair value during the 2002 recession. As it did in 2002, perhaps the massive monetary and fiscal stimulus on its way from governments around the world may keep valuations from sliding to their lower boundary.

The gain was due to the TSX 60 opening up 18% (HXU provides 2x the index return) and the ETF market makers apparently letting a 9% premium slip (in as the rush of buy orders likely overwhelmed their arbitrage operations at the open).

I knew I should have been watching the open in case there were some oversized profits to take. With world markets up 10% and more the day before, a big opening was a foregone conclusion. I even made a mental note to log on at 9:30 am.

But I got wrapped up with some work assignments and editing my wife’s course assignment (it’s her fault, I’m saying). By the time I looked at the clock, it was 10:30 am and by then HXU was down to a 20% gain. Too late, I thought. So I went back to work and did some errands. By the time trading closed today, the gain stood at 13%.

Note to readers: The HXU is in the explore part of a core & explore portfolio. I don’t recommend taking large positions on short-term trades with leveraged ETFs.

Sideways market reaction suggests expectations of more rate cuts ahead.

I guess that’s good news?

Besides, “history also shows that even from a time standpoint both the bear and the economic downturn are getting into late innings,” continues Trapeze. “The markets topped out almost a year ago. But bear markets are relatively short-lived compared to bulls. The average duration of bear markets over the last 50 years has been 8 months. …According to Ned Davis Research, on average, bear markets bottom 4½ months before recessions end and several months before earnings trough.”

There is evidence that a bottom has been reached. Notes Trapeze: “Pessimism is rampant… Cash on the sidelines is a record $8.5 trillion, over 20% of all U.S. household assets …. Short interest is at record highs (18.1 billion shares at the end of June)…”

“Contrary indicators support a bottoming market. According to Merrill Lynch’s monthly survey, institutional investors are at a record underweight stocks and overweight cash. The put/call ratio … is high. There is a record number of new lows (1,304 NYSE new lows on July 15 vs. only 19 new highs), reflecting severe pessimism. The Volatility Index recently got through a high of 30. Investment advisory services are net bearish and corporate insiders, the ultimate contrarians, have stepped up their buying relative to selling, a very bullish indicator. New issues are at 2001 lows.”

“… market psychology has been as ugly as it gets and investors have been dumping small cap stocks, regardless of fundamentals. According to Ned Davis Research, small caps begin to outperform large caps 4 months before recessions end. A clear opportunity to any sensible investor … our energy holdings are at outstandingly low valuations. You had better believe big cap energy, which is having trouble reinvesting its outsized earnings, is looking at cheaper and faster‐growing small cap energy for investment opportunity.”

But wait for it. When the dollar fell 30% in real terms from 1985 and 1991, the trade balance went from a deficit equal to 3.5% of GDP to approximately balance. This time around oil prices have climbed and masked some of the reduction. And most of the dollar depreciation since 2002 has come in the second half of the period (converse of earlier devaluation) — so much of the effect is still to be felt (given long lags of up to two years in the impact of exchange rate changes).

Extrapolating from the 1985 to 1991 experience, John Lipsky, First Deputy Managing Director of the International Monetary Fund (IMF), expects the U.S. trade deficit will decline in coming years to under 3% of GDP. For investors, this means a promising asset class going forward could be U.S exporters. As Lipsky said: “If the decline in the value of the dollar is supporting a narrowing of the … U.S. current account deficit, it is thereby helping to promote an inevitable shift in the sources of growth between tradable and non-tradable sectors in both surplus and deficit economies.”

On his fifth day cross-examining Maria Messina, Edward Greenspan – the defence lawyer representing Drabinsky – accused the former Livent chief financial officer of concocting a story where former Livent accountant Chris Craib told Messina about a meeting held on April 24, 1998 where Drabinsky and Gottlieb allegedly openly discussed manipulations to Livent’s books. Messina testified that Craib called her late that evening and told her about the fraud and she wrote a memo about the call after consulting with a lawyer. “I’m going to suggest to you that Craib banded together with you to create an entire story to put the blame on others,” Greenspan charged. “You and Craib decided to put the blame on what was happening in the accounting department on Mr. Gottlieb and Mr. Drabinsky.”

As for the notes of the conversation she had with Craib. Greenspan alleged that Messina wrote the memo months later as back up for her concocted story.

“That is so nonsensical, sir. It is not correct,” Messina replied.

As evidence to support this theory Greenspan cited a “flip-flop” in Messina’s testimony about when she contacted that lawyer. Messina told several investigators that she contacted her lawyer after Craib’s late night phone call. However, Messina’s calendar shows that the first meeting occurred the day before the Craib call, Greenspan suggested. And at that meeting, Messina made not mention of any ongoing fraud at Livent.

Messina disputed that there was any significant discrepancy in her testimony. She agrees that she did indeed call the lawyer before the Craib call, but that call was over her suspicion that Livent officials were going to continue to allegedly cook the books – fears that were confirmed the day after that first meeting. She did not refer to the first meeting in her statements to investigators because the meeting was pretty much a bust. She had intended to disclose the ongoing alleged fraud, but lost her nerve at the last minute when the lawyer told her: “Maria Messina – a professional chartered accountant and woman of integrity would not let that happen.” At that point, she didn’t have the heart to disclose to the lawyer that she already had let it happen.

“I was humiliated and ashamed and didn’t have the guts to tell him I was already associated with the fraud,” she told the court.

Greenspan has already disputed that the meeting ever took place – and certainly it could not have taken place on April 24th. Former Livent vice president of finance and administration Gordon Eckstein also testified he attended the meeting where alleged accounting manipulations were discussed but could not remember the exact date of the meeting. It couldn’t have been on April 24th, Greenspan maintained, since Drabinsky and his girlfriend at the time (or his “mistress,” as Eckstein testified) were in Washington attending a lunch hosted by then-U.S. President Bill Clinton.

Greenspan has accused Eckstein of being the real mastermind of the fraud and yesterday expanded that to include Messina. After all, Messina did not disclose the fraud to accountants working for KPMG who pored over Livent’s books during a due diligence examination of the company in the spring of 1998 prior to former Hollywood mogul Michael Ovitz investing in the company, Greenspan said.

“You didn’t go to him and say, ‘Are you nuts?’” Greenspan asked.

“No,” replied Messina.

“You don’t go to him and say, ‘Are you out of your mind? Why didn’t you give us a heads up?’” Greenspan said. “I am going to suggest to you that he would say to you, ‘I don’t know what you are talking about,’ because he didn’t know about the fraud.’”

“That’s a complete absurdity,” said Messina.

But how to explain all those documents with Drabinsky and Gottlieb’s handwriting on them showing explicitly the millions of dollars of manipulations to Livent’s financials? Well, Greenspan’s got a theory about that too: the notes aren’t really instructions to manipulate the books at all, Greenspan suggested.

For instance, On a draft financial statement for the year-end of 1997, Drabinsky wrote “roll forward” next to entries for Livent’s office expenses and theatre operating expenses. Those notes, the prosecution alleges, are instructions to manipulate those entries. And indeed in the next draft of the financials, entries for more than $4 million in office expenses are slashed, as are expenses of about $775,000 for the Pantages Theatre in Toronto and $870,000 for the Ford Centre in Vancouver. However, in the final version of the financial statements – the ones actually presented to investors – those numbers are actually higher than in the original draft. “Are you suggesting that Garth Drabinsky giving instructions for those expenses to be manipulated and no one is listening to him?” Greenspan asked.

“Everything changed in the various versions of the financial statements because nothing made sense,” Messina replied. She tried to offer to take Greenspan through the entire document and explain each of the manipulations, but Greenspan cut her off.

The case resumes July 7.