DON'T BE AFRAID TO BE BEARISH ON GLOBAL EQUITIES (July 26, 2010): There has recently been a very sharp surge in investor and analysts' bullishness toward the stock market, as the S&P 500 index today moved back above its simple 200-day moving average. This has encouraged numerous chartists and momentum players to cover their short positions and to jump back aggressively onto the long side. In my opinion, this is a serious mistake. The weak performance of commodity shares since they peaked mostly in the first half of January 2010 is an important leading indicator for general equities, just as commodity shares had bottomed in November 2008 and thereafter began to form a bullish pattern of higher lows well ahead of the early March 2009 nadir at a 12-1/2-year bottom for the S&P 500 index. U.S. Treasuries have also been quite strong since early April 2010; whenever Treasuries and equities disagree about the future direction of the worldwide economy, almost always the stock market catches up to Treasuries rather than the other way around.

In addition to regaining its simple 200-day moving average, the S&P 500 currently stands at almost exactly the halfway mark between its April 26, 2010 nineteen-month peak of 1219.80 and its July 1, 2010 ten-month low of 1010.91. There is nearly a unanimous consensus that the remainder of the summer will see equities remain within a narrow trading range in continued light volume, and since any nearly unanimous consensus is virtually always wrong, we will get a breakout in one direction or the other--or perhaps both. Since there has been very little talk from the bearish camp in recent days, I expect that a downside breakout to roughly 950 for the S&P 500 within a few weeks of Labor Day (September 6, 2010) is the most likely outcome. This will likely be followed by yet another recovery above 1100 for this index.

In the longer run, the picture remains extremely negative. I still expect the S&P 500 to plummet below 500, and perhaps even below 400, within roughly two years. The 1929 stock-market crash was followed by a recovery of more than half by April 1930, and then the Dow Jones Industrial Average plummeted by 86% by July 1932. While an 86% collapse is probably too negative a forecast, a two-thirds pullback by 2012 is much more likely than is currently believed to be the case. Every recession since the 1700s has been accompanied by a dividend yield of at least 6% for a basket of large-cap U.S. companies, and with the worst housing collapse in U.S. history, I can't imagine why the current era will be less extreme. If anything, it should be more severe than average. Barring a highly unusual surge in dividend payouts, to get to a 6% dividend yield for the S&P 500 index would require the S&P 500 to slump below 400. This would represent a pullback of more than 64% from its current price, and more than two thirds from its April 26, 2010 zenith.

Some analysts claim that investors are not as bullish today as they were two years ago, because they have less of their net worth invested in equity index funds. However, the only reason for the switch is that many investors still have a strong negative association with such funds, having lost more than half of their money in equity index funds from October 11, 2007 through March 6, 2009. Therefore, as amateur fund flows have clearly indicated, there has been an all-time record surge during the past year into high-yield corporate bonds and emerging-market equities. Investors have deluded themselves into believing that they are more diversified in 2010 than they had been in 2008, but it is a false diversification. If global equities plummet by half or more, then high-yield corporate bonds and emerging-market equities will plummet approximately as much as equity index funds in percentage terms. Diversification only works if assets are uncorrelated; in this case, even owning a few hundred different securities is meaningless if all of those securities end up losing more than half of their value. Those who thought they were protected in 2008 mostly discovered the hard way that a falling tide sinks all boats. Only long-dated U.S. Treasuries and their funds like TLT are likely to be an exception to the rule, especially as these remain highly unpopular with most investors over irrational fears of rising interest rates and increased inflation.

GDX is a fund of gold mining shares which has continued to form a pattern of lower highs since it had peaked in March 2008. Over the same period of time, gold bullion has been forming numerous higher highs. This is a profoundly negative divergence which clearly signals that investors' fears of rising inflation are completely unfounded, at least for the next year or two. The real risk is deflation, which is why nearly all funds of commodity shares from mining to energy to agriculture have been particularly weak in 2010--with a pattern of numerous lower highs during the past half year.