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So, Is This a New Bear Market or What?

If you back out emotions, things actually look pretty good


Annoying, isn’t it? Just when you were sure the market was ready to begin a new bear market following last week’s big plunge, along comes an exceedingly bullish day like Monday to stop the bleeding and offer a glimmer of hope.

Although stocks are poised to start Tuesday slightly in the red again, it’s hardly looking like a nasty selloff. It just looks like a little profit-taking … the kind you’d expect after a sharp (and surprising) rally. The bulls could shrug it off if they decided to.

The market’s current schizophrenic nature begs just one simple question: Should we be getting bullish or bearish here?

The good news is, there’s an answer — we just have to defer to a higher authority first before we can pen it.

Put It in Perspective

The market’s a bit of a mess right now, to be sure. However, what’s happening to fuel this recent volatility is clear.

What’s the cause? Benjamin Graham — the grandfather of value investing — lays the foundation for the answer with his brilliant (and too-often forgotten) observation, “In the short term the market behaves like a voting machine, but in the long term it acts like a weighing machine.” It’s his way of saying short-term trends that are measured in days or weeks are driven by sometimes-irrational emotions, but long-term trends measured in months eventually will push stocks toward appropriate, earnings-based prices.

Folks, whether the media wants you to believe this or not, the big plunge suffered during the prior three weeks was an emotionally charged “vote,” and not a reflection of the market’s value. Europe — and Greece in particular — China’s slowdown, unemployment and the calendar collectively spurred us all into a bearish frenzy, as we assumed (we were told?) a combination of those pitfalls surely would impact stocks’ values.

It’s worth noting the oversized rally we all enjoyed between the middle of December and the end of April was also an emotionally charged “vote” … just a vote for the bullish camp. It was the knee-jerk reaction to the realization that the United States’ debt/budget debacle from August wasn’t going to blow up in our face after all.

Both trends were built on emotions. Neither trend really considered the market’s actual present or realistic forward-looking value.

So what is the market actually worth?

The Truth Is …

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Where should stocks collectively be priced based on trailing and plausible forward-looking earnings? As so often is the case in life, the truth is somewhere in the middle of two diametrically opposite schools of thought; the market was overpriced at April’s peak, yet underpriced at last week’s deep lows.

Aside from the fact that the market is undervalued at current levels, though, there are two important ideas we have to embrace: (1) Stocks are poised to keep going higher (in the long term) because we’re still in a bull market, (2) which still is being fueled by measurable growth from key economic indicators.

Bull Market Still Alive and Kickin’

As for the market’s bigger bullish trend still being intact, it’s an idea I partially explained last week. Though the selloff at the time was feeling harsh, it was nothing we hadn’t seen at that time of year in the prior two years. Indeed, it’s something we see on a regular basis in the summertime.

But more than that, the pullback to date has only taken an 8.5% bite out of the market — right around the average bull market correction. The pros say a bear market is classified as a dip of 20% or more. I’d be even more defensive and say a 15% dip is a worry. Thing is, we’ve not hit either of those bearish milestones yet.

And yes, the underlying earnings growth needed to spur rising stock values is intact. Despite worries to the contrary, the S&P 500 is on pace to keep posting new-record trailing bottom lines through the end of 2013.

Economic Growth in All the Right Places

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The supporting evidence of continued economic growth — the kind needed to keep the earnings growth trend in place — is delivered by the underappreciated duo of capacity utilization (the proportion of our manufacturing capacity being used right now), and the productivity index (how much stuff we’re actually making and selling).

Fewer investors care about these two data sets compared to, say, unemployment figures or GDP growth. However, the correlation between capacity usage and productivity versus the long-term market is better than I’ve seen with any other piece of economic information. If they’re rising, so too is the market. If they’re falling, so too is the market.

Well, ladies and gents, as the nearby chart illustrates, both of those economic indicators were still rising as of last week. They might not stave off short-term bearish ebbs and flows, but when you look at the longer-term monthly chart, the correlation and the current trend are what they are.

Bottom Line

If you just wanted to sit the summer out and let the dust settle before wading back in, I can’t say I blame you for that. It’s tough to see through the fog here, and it’s even tougher to not follow the media-led crowd — even if you know they’ve misled you before. Just don’t stay out of the pool too long. Any further downside is apt to be limited, and we should start to see more long-term upside by September or October (at the latest). The bigger-picture data still looks too encouraging to be a discouraged long-term investor, even if you’re hearing otherwise.

Invest with your head, not your heart.

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