Beginning of a new phase in Stock Market?

Last week belonged to the small and medium capitalisation stocks. They continued their dizzying climb even as the broader market remained stable and range-bound. The much-anticipated correction in the stock markets did not happen. Hence, many investors are now grappling with the question, whether the recent gains in stock prices are a bear market rally or the start of a brand new bull market.

The reason for such a doubt in their minds, despite this strong rally, is due to the fact that there have been many counter trend moves or rallies since the bear market began in January 2008, and all of them petered out within a couple of months. The economic fundamentals were not strong enough to support them.

Markets ignore fundamentals:

The fundamentals don't seem to be driving the stock markets in this rally too. The world continues to fight the financial crisis, many economies are in doldrums, policymakers are taking corrective actions in fits and starts without any continuity, and industries are clueless about the demand environment. Yet, the markets rallied. They rallied ignoring all bad news and somehow converting bad news to good news - American banks' stress test results and swine flu.

The rally has caught everyone by surprise in terms of its length and durability. After stocks rallied nearly 30 per cent off their lows, analysts now agree that it's a new bull market.

Stimulus programmes:

The current global situation is similar to that of the one in Japan in the 1990s. Japanese stocks participated in some significant rallies during that decade, with three rallies of more than 50 per cent gains in stock prices. They were triggered by government spending and stimulus programmes.

These rallies are described as cyclical bull markets within a structural downtrend. Bear markets contrary to popular perception do not mean an unabated dip in stock prices and the economy. There are sharp rallies that do not last long and the decline in the markets after that is sharper. Similar conditions exist today, with enormous sums pumped into the economies by governments across the globe. The trillions of dollars in spending programmes can indeed stimulate the economy, at least for a few quarters, reviving growth this year.

However a broad consensus is that the US-led global economy faces too many structural problems to enter into a meaningful expansion phase. That is a correct estimate, but in the long term.

Portfolio rebalancing:

Another reason for this sharp rally is rebalancing of H S Murali portfolios by global institutional investors. Pension funds and other institutional investors have model portfolios, set by investment committees. A typical portfolio would consist of equity, bonds and hedge funds with a predetermined percentage for each of them. As the bonds did well and equities fell sharply, they had to rebalance their portfolios by selling bonds and buying equity to get back to their model portfolios.

Earlier, this sort of rebalancing happened automatically. The automated route was suspended due to the fears arising from colossal upheavals in all asset classes last year. The 30 per cent plus rise in prices in the markets has put immense pressure on institutions to get the portfolios back on track. Hence, they are on a buying spree.

Investment strategy: Does the current 30 per cent plus rally off the bottom mean that the bear markets are over and that it's finally safe to invest for the long term? The answer to this question is still eagerly awaited. Institutions are holding billions of dollars in cash waiting for the right signals. These funds have to be eventually invested. So, any correction in the markets may be small and shallow. Analysts are quick to warn that many challenges remain. During the great depression of 1929-32, the Dow Jones Index had a total of five 20-per cent plus rallies over the course if its 34-month decline of 89.2 per cent. The first one was a massive 48 per cent rally and the last rally was of 24.6 per cent, followed by a final decline of 53.6 per cent.

Investors can hope that the latest rally will prove to be the beginning of a new bull market. But history suggests we proceed with caution in our financial planning. At the moment the stock markets have risen too sharply and too quickly, and to build a strong base for a good bull market a pull-back is required. The fundamentals still do not support a full-fledged bull market. Hence, it makes sense for investors to stay away from irrational exuberance. While many good stocks are available at significant discounts to their actual worth, it would be advisable to buy into such stocks when there are corrections in the broader markets.