But there are still a few lone bears roaming the commons. Of note is Charles Biderman, CEO of TrimTabs Investment Research. His latest analysis of daily income tax deposits to the U.S. Treasury projects 358,000 U.S. jobs lost in September, almost double the consensus estimate.

A TrimTabs study concludes job losses “are contributing to record mortgage delinquencies, which will be a drag on economic growth for several years. In addition, defaults have spread to commercial real estate loans, credit cards, and commercial and industrial loans.”

Mr. Biderman adds: “Consumers are in terrible financial shape despite the trillions of dollars the government has spent on bailouts and stimulus programs. When investors realize how weak the economy truly is, stock prices are going to plunge.”

Stress tests may have some teeth after all

Krishna Guha, Financial Times of London
“A Fed white paper on the tests revealed that regulators ignored recent changes that water down mark-to-market accounting rules when assessing how much of a capital buffer each bank needs to ensure that it could comfortably survive a deeper recession than expected.
This is likely to result in some banks having to raise more equity than they would have done if the new accounting guidance had been applied, resulting in a stronger capital buffer but also greater dilution for existing shareholders. Regulators also took an expansive view of the risks banks need to hold capital against, including off-balance-sheet exposures and counterparty credit risks.”

Insiders dumping shares

Michael Tsang and Eric Martin, Bloomberg news
“Executives and insiders at U.S. companies are taking advantage of the steepest stock market gains since 1938 to unload shares at the fastest pace since the start of the bear market”

The coming tidal wave of corporate bond defaults

Floyd Norris, New York Times
“So it went with the subprime mortgage crisis. And so it is now going with corporate loans and bonds. It appears that defaults on leveraged loans and corporate bonds will soon rise to levels not seen since the Great Depression …. One reason for the rise in defaults is that this is a severe recession. But it is not the principal one. Junk, circa 2009, is the worst junk ever …. Calculations by Moody’s Investors Service show that as of the beginning of April, a record 27 percent of speculative-grade debt issuers had a rating on their senior debt ranging from Caa down to C.”

Banks getting the wrong medicine

Daniel Hofmann, chief economist at Zurich Insurance Co.
“… big, troubled U.S. banks represent a large part of that country’s economic woes, but are being given the wrong medicine … The problem …is that the U.S. government has been treating banks as if they had a liquidity problem, while in fact they have a solvency problem …. The two problems are very different: you need liquidity if you owe $100 tomorrow, but your only asset is a $100 item that will take a week to sell. All you need is a short-term loan …. But if you owe $100 tomorrow and your sole asset is worth just $50, you have a solvency problem ….Those who see a solvency problem don’t believe that all the U.S. plans to create a market for bad bank assets will work. These plans assume that the assets have significant value and buyers just need some encouragement …. But if the assets are worth very little, some big banks are insolvent. Then, the only cure is to close them, let their investors and lenders take a loss and peddle the assets for whatever they’re worth …. If that’s the case, the longer government waits to administer this bitter medicine, the longer the U.S. will have a hobbled banking system and substandard growth.”

Retest of March low coming?

Mark Hulbert, MarketWatch
“… new bull markets often retest the lows of the bear markets that preceded them. That means that, even if a new bull market is now underway, it is not necessarily essential that you immediately increase your equity exposure …. Consider what happened after the 2000-2002 bear market came to an end on Oct. 9, 2002 .. The bottom line? Even if the train has left the station, there’s still a good chance that it will return to pick up more passengers.”

One argument against having the Big Rally in 2009 is that it’s still too early. During the Great Depression, it came 4 years after the peak of the previous bull market. We are only about two years past the peak of the last bull market. Then again, policymakers this time around reacted with massive stimulus sooner than was the case in the 1930s, so perhaps the Big Rally could get here sooner.

Ultimately, it will be up to the economy. “It was early glimmerings of a recovery in the U.S. economy that ignited and fueled the rally; the tone of economic data over the next few months should be what keeps it going or not,” I wrote in an earlier post, Is this rally for real?

So let’s generate another installment in the mash-up that was started in the above post and continued in a second post, Rally Gone Overboard? This time the focus is more on the real economy than financial markets (as it was in the previous post). Again, the flow of data and commentary has a large strand of skepticism. But some of it does shine a light.

Highlights from the data/comments flow

Optimism may be fashionable, but there are plenty of reasons to fear it is premature. The upbeat thesis focuses on firms and their inventories ….The danger, however, is that too much emphasis on the [inventory] cycle misses the underlying characteristics of this downturn. This is mainly a balance-sheet recession precipitated by a financial crisis. And it is a downturn that it is unusually synchronized around the globe. Economist magazine.

“The recession is very likely to end sooner than people think [ECRI's weekly leading indicator of economic growth, which has a good record of predicting business cycle turns, just hit a six-month high]” Lakshman Achuthan, managing director at the Economic Cycle Research Institute, (ECRI).

A Reuters/University of Michigan measure of U.S. consumer moods jumped more than four points to 61.9 in April, the highest reading since September.

“In March, the year-to-year decline in U.S. industrial output of 12.7% was the result of reduced U.S. demand, inventory cutbacks and recessions abroad … it was the largest since the factory sector’s wind-down following World War II,” Haver Analytics.

“… deleveraging by highly leveraged firms, such as hedge funds, will lead them to sell illiquid assets in illiquid markets … [and] some emerging-market economies, despite massive IMF support, will experience a severe financial crisis with contagious effects on other economies,” Nouriel Roubini, Professor of economics at the Stern School of Business.

The CBOE Market Volatility Index was 36 on April 16, edging down from the 40 level of recent weeks and noticeable lower than the peak of 80 in October 2008. But before the bear market, the VIX was hovering near 10.

The $787 billion stimulus program is flawed because too much spending comes after 2009, and because it devotes too much of the money to tax cuts, Nobel prize economist Joseph Sitglitz.

“ … there are some encouraging signs that support cautious optimism. I do not expect a strong recovery but I do expect the economic contraction we’re now experiencing to give way to slow and tentative growth as early as the third quarter.” Dennis Lockhart, president of the Atlanta Federal Reserve

“Over just the last three months, business inventories have fallen at a 15.2% annual rate, a record for the series which dates back to 1980 … Lower business sales [and prices] continue to propel the inventory correction … they are down at a 16.2% annual rate over the last three months … The inventory cutbacks overall, however, have done little to reduce the I/S ratio for total business … It remained in February near its highest level since 2001,” Haver Analytics.

“Taken together, both (housing and jobs) releases will put a damper on the nascent optimism we’ve seen in the markets in the past couple of weeks,” Matthew Strauss, senior currency strategist at RBC Capital Markets.

“Consumers spent less [in March], sending sales skidding 1.1 per cent from February …
This week’s Chapter 11 filing by General Growth Properties, the second-largest mall owner in the U.S., [could be] a bad omen for what ails the U.S. economy … If consumer spending stalls at current low levels, brace yourself for more retail and mall bankruptcies, in the U.S. and elsewhere.” Barrie McKenna in the Globe and Mail.

The fundamentals in terms of corporate profits, house prices and bank lending have not yet bottomed; valuations are not yet at fire-sale levels — the cyclically adjusted price-earnings ratio is 14.5 compared with previous bear-market lows in single digits. Teun Draaisma, Morgan Stanley strategist

I agree with those who say investing is as much about character as it is about analytical capability. Character is about having strength in the face of adversity, of being able to hold onto what you believe in while others around you are losing their moorings. It’s about following your own counsel regardless of the crowd view. It’s about having perspectives such as the following:

1. Things are easier to endure if you maintain a healthy balance in lifestyle – proper diet, fresh air, exercise, and other diversions. In Ottawa, a good two-hour skate from one end and back on the canal (world’s longest skating surface) does wonders for clearing the mind. So does a trip away somewhere where the activities are guaranteed to occupy you, like a visit to a cross-country ski resort in the Laurentian Mountains north of Montreal. Needless to say, checking your account and the pulse of financial markets every hour is not part of the prescription.

2. Using mental imagery techniques may help – for example, envisioning what the stock market will look like three to five years from now. Chances are it will be more like the beginning or middle of the last bull phase, from 2002 to 2007. All this anguish will be a faint memory.

3. As mentioned in my column, Why investor’s get burned, realize we are in the phase of the bear market when all the doomsayers look like they were right and are getting major air time in the media. After awhile, they begin to sound plausible. The bottom in the market is four years away says one. Civil unrest in the streets says another. So like Ulysses, you have to “tie yourself to the mast” lest the Sirens’ song lure you into changing direction or jumping into the sea.

4. If the thought of having lost so much money wears on you or even keeps you awake at night, get proactive with making and executing plans for recouping some of the losses via application of your human capital. That is, you may be able to leverage your career training and experience more. Perhaps that might require spending less time on hobbies and more time in income earning pursuits.

5. Keep in mind the history of stocks markets. For example, the greatest rally in the market occurred in the midst of the Great Depression, when the Standard & Poor’s 500 Index rocketed over 100 per cent during the three months from July to September of 1932. The second greatest rally also occurred during the Great Depression, in the 1933, the year after the first greatest rally.

That refuge is my library of investing books. Last night, the respite came from William Bernstein’s The Four Pillars of Investing – specifically Chapter 6: ‘Bottoms: The Agony and the Opportunity.’ Referring to the vicious bear markets of 1932 and 1974, he writes:

“The rewards of fishing in such troubled waters are staggering. For the 20 years following the 1932 bottom, the market returned 15.4% annually, and for the 20 years following the 1974 bottom, 15.1% annually.”

How to handle the panic? Here’s Bernstein again:

“At a minimum, you should not panic and sell out – simply stand pat. You should have a firm asset allocation policy in place. What separates the professional from the amateur are two things: First, the knowledge that brutal bear markets are a fact of life and there is no way to avoid their effects. And second, when times get rough, the former stays the course; the latter abandons the blueprints, or, more often than not, has no blueprints at all.” 

Bernstein wrote his book in 2002, but I’m sure he would agree it’s quite the distinction for the Boomer generation to get caught up in two bubbles in quick succession:

“The Great Internet Bubble will not be the last the last of its kind. But if history is any guide, we should not see anything approaching it until the next generation of investors takes leave of their senses, sometimes around the year 2030. If the current generation gets caught out again, we should be very disappointed, as no previous generation has been so dense as to have been fooled twice. But then again, the Boomers have shown a singular talent for gullibility, and there is still plenty of time.”

Unfortunately, during the bull market that ran to early 2008, many people thought they were diversified if they spread their 70% to 90% equity allocation by geography, industry, and market cap. So now diversification is taking a bit of an unwarranted rap on the knuckles.

Activa also has a calculator showing the impact of diversification over bear/bull cycles in the stock market since 1968. For the most recent cycle, from September, 2000 to May, 2008, Activa’s diversified portfolio finished 53% higher, while the all-stock portfolio finished 48% higher. The all-stock portfolio may have raced ahead during the bullish phase but wasn’t able to compensate for the huge losses incurred during the bearish phase.

However, during the previous six bear/bull market cycles back to 1969, the all-stock portfolio ended up higher in four of them. So, being diversified doesn’t always win. Whether you go with a stock-intensive or diversified portfolio would seem to be more a matter for risk preference. And of course time period is important too: it is generally believed stock-intensive portfolios would be suitable for young persons saving for retirement. Endnote: Activa’s calculator used total return U.S. indexes (and 10-year government bonds).

“The United States invariably does the right thing, after having exhausted every other alternative.” Winston Churchill 

“Stop experimenting with your savings.” Ad on Yahoo Finance, promoting ING Direct’s high-interest savings account. 

“When there is a stock market boom, and everyone is scrambling for common stocks, take all your common stocks and sell them,” he elucidated. “Take the proceeds and buy conservative bonds. No doubt the stocks you sold will go higher. Pay no attention to this–just wait for the depression which will come sooner or later.” When this depression–or panic–becomes a national catastrophe, sell out the bonds (perhaps at a loss) and buy back the stocks. No doubt the stocks will go still lower. Again pay no attention. Wait for the next boom. Continue to repeat this operation as long as you live, and you’ll have the pleasure of dying rich.” Fred Schwed, Where Are the Customers’ Yachts? 

And once in, you might consider staying. Studies by leading academics such as Kenneth French and Eugene Fama find that small caps average 12% annually over the long run.

The current downturn for small caps is the worse of the past seven says Sartz. Small cap indexes are down by over half. Past declines were 28% to 43% from market peaks. The spring back after the 2008 bear could be exciting. 

We are in the midst of tax-loss selling season too and a lot of small caps are down for that reason. If past tendencies emerge, January could see good snap back.

So small-cap exchange-traded funds (ETFs) look like good places to deploy funds if you are one of the brave now looking to buy low and sell high. In Canada, there is the iShares CDN SmallCap Index Fund. In the U.S., there is:

• iShares Russell 2000 Index
• iShares Russell Microcap Index
• SPA Market Grader Small-Cap 100
• First Trust Small Cap Core AlphaDEX
• PowerShares Dynamic Small Cap
• RevenueShares Small Cap

The day before, markets retested the Oct. 10 lows in convincing fashion. They looked past the jump in U.S. jobless claims to stage a spectacular rally in the afternoon. On Friday, a plunge in U.S. retail sales hit markets in the morning but a rally again took hold during the afternoon and was edging into the green by 3PM when dumping by mutual/hedge funds brought the market down the express elevator to the day’s lows.

In short, it looks like the customary rally from a retest of the bear-market’s low faces greater headwinds compared to past cycles. In one corner, we have the technicians bidding up the market on expectations historical patterns will repeat. In the other, we have the immeasurable impact of forced deleveraging (including a contraction in lending).

Then, fourth-quarter earnings are due in January. Brokerage analysts, as usual, are still behind the macroeconomic curve as it enters the downturn phase. Their estimates are starting to come down, but they are still “far from throwing in the towel on their earnings forecasts,” as Peter Lim wrote in the New York Times.

According to a Thomson Financial survey, analysts still expect S&P 500 companies to grow profits more than 12% in 2009. Given they aren’t expecting much for the first two quarters of 2009, the estimates imply “a tremendous profit surge in the latter half of 2009,” noted Lim. In January, therefore, there could be a raft of poor earnings releases that knock earnings projections down even lower. So it looks like a toe-dippers’ market still.

Will the upturn hold? There is, no doubt, still a lot of bad news in the pipeline. It could arrive as soon as the morning after the “spectacular rally,” with the release of U.S. retail figures. But if a true bottom is in place, at least for the intermediate term as many technical analysts argue, the market will ignore bad tidings and continue to climb. The G-20 meeting on the weekend may also lend support early next week.

The pessimists point to still high interest-rate spreads in the debt markets. And Libor rates are still elevated, and, in fact, have recently reversed their steady decline that commenced mid-October. Credit conditions need to ease more, it is suggested. And Ground Zero, the U.S. housing market, still shows few signs of bottoming out: inventories of houses for sales remain high, as do defaults.

Indeed, the LEIs are beginning to suggest the recession will be at least as long as the 16-month downturn in 1981-1982. If they are right and the S&P 500 bottoms two to four months before a recession ends, then the current bear market will likely continue until mid to late 2009 (assuming the current recession began July, 2008).

What are the LEIs saying? Let’s focus on the 40% decline in the Journal of Commerce Industrial Commodity Price Index since its high in July. That’s the “most since 1949 and worse than the declines before every recession since then,” said Bloomberg.

The collapse in the index shows a collapse in the manufacturing sector. “The industrial sector, which was helping to keep the recession relatively mild, has completely given way and now we need to be prepared for a much more severe recession,” said Lakshman Achuthan, managing director at the Economic Cycle Research Institute, which compiles the Journal of Commerce data. “It’s at least going to look something like what we saw in the early 1980s, but it could be worse.”

The Bloomberg article adds: “The commodity decline coupled with economic data signal the current slowdown will last at least 16 months and spur slowdowns globally, not just in the U.S. and Europe, ECRI’s Achuthan said. The slumps of 1990 and 2001 lasted eight months, according to NBER data. ‘As is usually the case, the commodity index is ahead of consensus right now and indicating just how deep and how long this global recession will be,’ Achuthan said.”

ECRI has one of the best forecasting records within the economics fraternity, in my opinion. It was founded by Geoffrey Moore, father of LEI analysis (and professor to Alan Greenspan). “ECRI is perhaps the only organization to give advance warning of each of the past three recessions; just as impressive, it has never issued a false alarm,” said the Economist magazine back in 2005.

The S&P 500 turns up 2 to 4 months before the end of the recession according to Northern Trust and the average length of the a U.S. recession in the post-war era has been 10 months according to Bespoke Investment Management. So if the recession began in early to mid-2008, we could be near the bottom going by historical norms.

We’ll know when the recession officially started when the National Bureau’s Business Cycle Dating Committee makes its call. A rule of thumb is two consecutive quarters of negative growth in GDP. What can make it tricky are ongoing revisions to GDP growth figures.

Another historical norm suggesting a bottom is the typical decline seen in bear markets. Nick Majendie, a portfolio strategist at Canaccord Adams says “…there have been 12 occasions since 1900 when the Dow Jones Industrial Average has been down more than 40%, and in 11 of those periods, the drop stopped somewhere between 40% and 50%.” That’s where markets were last week prior to the rally.

However, historical norms may not apply this time around considering the severity of the current financial crisis. Indeed, a recent IMF study concluded: “Recessions preceded by banking crises last twice as long on average as those not triggered by a financial crisis, and the loss of output was about four times as great.

Bert Dohmen editor of the Wellington Letter, is bearish too: “Most bear markets, after a major bubble has burst, decline 80%-90%, going back to where the bubble started. In the United States, that’s what happened after the 1929 Crash. During the 1973-74 bear market, the broad ValueLine Index was down over 80%. In 2000-02, the Nasdaq Composite was down over 80%.”

Brian Tang, president of Fundamental Research Corp., can vouch for that. Using data from Reuters Knowledge (in U.S. dollars), his company recently screened for stocks trading below their net cash value on North American exchanges. For good measure, they screened out those with price-earnings ratios above 10 and three-year revenue growth under 5%.

They found dozens, which were winnowed down to 19 that might be worth further research. Three on U.S. exchanges were: Thomas Group Inc. (TGIS), Trident Microsystems Inc. (TRID), and TTI Team Telecom (TTIL).

TGIS, TRID and TTIL have market caps of $13.2 million, $119.4 million, and $17.4 million, respectively. Their cash holdings exceed market cap and debt by $1 million, $90 million, and $9.5 million.

There were just three on Canadian exchanges: HudBay Minerals Inc. (HBM), Orvana Minerals Corp. (ORV), and Jemtec Inc. (JTC).

HBM, ORV, JTC have market caps of $560 million, $47.5 million, and $1.6 million, respectively. Their cash holdings exceed market cap and debt by $47 million, $45 million, and $1.4 million.

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.”