Why the markets are up

To understand the rally, recognize that the GDP statistics you are reading are already out of date.

Equity markets around the world are surging in the face of the sickest global economy in more than half a century, a crippled banking system that needs billions of dollars of equity capital, a flu scare and house prices that are still falling at a dizzying rate. On April 30, the front page of The New York Times read ECONOMY SLIDES AT FASTEST RATE SINCE LATE 1950S. That same day, the German finance minister said his country would suffer “the worst recession since the Second World War” and that other European economies were in dire straits.

The declines have been even more severe in Asian economies such as Japan, Korea and Singapore, and most experts are skeptical about the better numbers from China. The “great minds” of the investment world and the most highly regarded economists are preaching gloom and doom and a generation of wealth destruction. The question now: why are stock markets going up when so many economic numbers are going down?

First, recognize that the statistics you are now reading are already out of date. The U.S. government reported on April 29 that real GDP fell 6.1 percent in the first quarter after a 6.3 percent drop in the fourth quarter, the steepest six-month decline in 50 years. Yet U.S. stocks rallied to a new recovery high the same day. Why? Because beginning in mid-March, there were signs of what Ben Bernanke called “green shoots” in the real economy, namely that the rate of decline, or the so-called second derivative, was decelerating. Some investors began to believe the world economy was bottoming out.

Now those green shoots are budding into foliage. In the last couple of weeks, there have been signs that the U.S., Germany and Asian economies are on the verge of not just bottoming, but rebounding. It’s beginning to appear that real GDP growth could be positive in the second half of the year—maybe even sooner. Leading indicators, including new orders and the purchasing managers survey, are rising. New home sales, the best leading indicator of the price of existing homes, seem to be stabilizing. Historically, the steeper the GDP decline, the stronger the rebound. Ed Hyman, the most highly regarded Wall Street economist, is talking about 4 percent real growth in the third quarter.

The second key reason markets are up is that most of the gloomy news that is on television and the front pages is already discounted in stock prices. Equity markets are looking ahead, not behind. Remember, this brutal bear market began in the summer of 2007, when the world still appeared to be booming.

As for the “great minds,” once they become celebrities they are wedded to their views. These newly minted heroes dash off books, and get paid big speaking fees. They become committed to their forecast. This is not just true of bears; it happens in bull markets, too. The point is that it is very hard now for the bears to reverse their position. Only the really good ones will.

The third reason equity markets are rising is the unparalleled amount of cash on the sidelines, which will eventually have to be invested. Money-market-fund cash is at a record 40 percent of the total U.S. market capitalization. Professional sentiment, which we monitor systematically, has risen some in recent weeks, but it is still extremely pessimistic. Major pension funds and endowments—which for decades have automatically sold stocks when they went above a preordained portfolio level, and then bought back into them when they went below the minimum—have suspended automatic buying out of fear. The 25 percent rise in prices we have already experienced puts immense pressure on them to at least get back to their minimums. The pain of missing a bull market is very severe. My guess is they will soon be buyers. We are talking about billions of dollars here.

The fourth reason for the rally is that credit and money markets have improved dramatically. Spreads on everything from high-grade corporate credit to junk bonds have narrowed. The three-month interbank lending rate, which affects so many other rates, has fallen from its recent high of 4.82 percent (right after Lehman failed) to 1.02 percent. And, of great importance, a large number of high- and low-grade credit deals are getting done.

Many analysts call this just a bear-market rally, which has about run its course and should be sold. Instead, I believe this is a cyclical bull market within a broad trading range, which means prices could go up another 10 percent to 20 percent. One signal to do some selling will come when you’re hearing about how much better the world is looking on CNBC television and from your friends. Another warning will be when the market no longer goes up on good news. We’ve still got huge legacy problems. The aftermath of saving the system through massive monetary and fiscal stimulus is bound to be unpleasant. The piper will eventually have to be paid. Using the S&P 500 as a benchmark, my prediction is that we’ll see a broad trading range somewhere between the March lows of 700 and the 2000 and 2007 highs in the area of 1450 to 1500 over the next few years. Be prepared: within this cage there will inevitably be periodic cyclical bull and bear markets to torture us.–Barton Biggs | NEWSWEEK

Biggs is managing partner at Traxis Partners hedge fund in New York.