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No clear winner in the battle of bulls and bears

Friday 14 December 2007 06:27PM

It is hard to recall a time in recent years when market sentiment was so polarised, or when convictions on either side of the fence were quite so strong.  It is making for a fascinating but stressful period for professional investors, some of whom, noted one weary hedge fund manager of my acquaintance last week, “may even have to earn their fees this year”.

There is no question that after the last couple of weeks the bulls are on the back foot. As the credit crisis unfolds, the banking sector is in full retreat and many commodities are showing signs of weakness after a belting year to date. To do exceptionally well this year, benchmark-driven fund managers have had to call two sectors right – short financials and long commodities. Where appropriate, it clearly helped to be short the dollar as well.

It may be no accident that in both the financial and mining sectors earnings forecasts are particularly prone to error, in the case of the banks, because of the difficulty in forecasting the level of write-offs and losses from the credit crisis, and in the case of commodities, because of both their inherent  volatility and the uncertainty about the impact that a slowing US economy will have on global economic activity. Those who have got both calls right are entitled to crow.

As a result the diversity of fund manager performance is increasing. The bearish hedge fund manager Crispin Odey, whose Odey European Fund is up 40% year to date, against his benchmark’s 9%, opened his latest report to shareholders with the comment “I think you think that I am enjoying this too much”.  Although broadly keeping to his absolute return remit, he has been bearish for a long time and underperformed badly in 2005 and 2006, so investors may feel that the recovery is overdue.

 According to the OECD, overall losses from the US subprime mortgage market crisis could reach as much as $300 billion, which would be two to three times the original estimate of the Federal Reserve made back in the summer. There are many others who think that the figure could yet turn out to be even higher still.  Bankers in general  seem to be in a funk, as well they might be, as slowly but surely the consequences of their herdlike behaviour are revealed for all to see.

"Thus far, equity investors” observes the OECD “seem to have shrugged off the negative sentiment that prevailed over the summer, but it may be too soon to draw firm conclusions. As adjustments have often occurred in waves, and as higher funding costs take typically several months to have their full impact on companies or consumers, it may well be that the recent correction is only a precursor of a more protracted downturn." The auditors of end-year banking report and accounts are another group who will be earning their fees this year.

The only thing missing so far is evidence of scandal. If history is any guide, when bubbles burst, they are almost invariably followed some time later by evidence not just of foolish behaviour , but of market abuse and illegality. It seems unlikely that the subprime crisis and its fallout will not in time add its own chapter to this unhappy saga of delinquency. 

The technical picture of the market on Thanksgiving Day last week also looked fragile. On Wednesday last week the Dow Jones Industrial Average fell through the August lows that many regard as a key test of the market’s resilience. Although the S&P 500 and the Wilshire 500 have yet to do the same, it is a warning sign that the reflation rally since August that the bulls have been counting on may turn out to be nothing more than a temporary mirage. Emerging markets however are still some 20% or so above their August lows. The S&P 500 closed in negative territory for the year.

A more encouraging sign for the bulls is that investor sentiment is becoming progressively less positive, which is a precondition of any significant market rally from this point.  Experience suggests that survey information about sentiment is of limited value, but anecdotal evidence is much more powerful .  My contacts with professional investors suggest that the first signs of genuine fear are now finally beginning to appear.

Market forecasters, J.K.Galbraith once observed, make forecasts not because they know, but because they are asked. At times of heightened uncertainty, it is never wrong, according to John Templeton, to increase levels of cash. It is good for the investor’s emotional resilience and preserves buying power for the moment when opportunities become more clear-cut. That seems good advice until the battle between bulls and bears has been settled more decisively.

A traditional end of year market rally now looks likely, but the odds on a traditional bear market occurring within 12 months are clearly rising. Many bank shares are probably cheap on a longer term perspective, but which ones? That uncertainty remains. The brave and far-sighted are going to make a lot of money. The strategic case for gold and agricultural commodities meanwhile remains strong.

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