Former analyst predicts "Nasty correction or years of treading water"

Former Merrill Lynch analyst Henry Blodgett recently wrote an article entitled "Is that finally it for the sucker's rally?"

His article makes use of some interesting charts, including this one from, which shows the recovery track of four legendary bear markets, including the most recent, the 2000-2002, the 1973-74, and the Great Depression.

Observing that each of the other three bear markets prior to this one went back and tested their low (the Great Depression not only tested its low but broke right through it to plumb new depths), Blodgett calls the 44.8% run-up in the S&P since March (blue line) a "sucker's rally."

While admitting that further gains from here are possible, he declares: "But it doesn't seem likely. More likely, we're in for another nasty correction or years of treading water, as the v-shaped recovery proves less vigorous than the market now thinks it will be."

Blodgett's article provides some insights into the reason he comes up with this gloomy prediction, primary among them being his clear acceptance of demand-side arguments for what drives the economy. His main argument is that the consumer will not be increasing his spending, and as everyone knows, the consumer "still accounts for a staggering 70% of the economy."

We have explained previously the problems with the Keynesian belief that the consumption, or demand, side of the equation drives economic activity -- most directly in 2007's "Happy Thanksgiving to All" post. It is a view that is so widespread and so often-repeated by the financial media that even insightful and experienced market observers such as Henry Blodgett can be sucked into buying it.

We believe the evidence that producers are the actual drivers of the economy, rather than consumers, is far more compelling. Investors should be wary every time they hear a prognostication based on the consumer being "responsible for 70% or 80% of the economy."

More importantly, we believe that comparisons of this market recovery to others from history are of limited value, due to some significant differences in the circumstances surrounding this particular bear market. We have provided extensive analysis which argues that the most recent bear market was brought about by a rare financial panic, very different from the conditions behind the 2000-2002 and 1973-1974 bear markets (see for example here and here). Based on this understanding, it is not surprising that the current market recovery has been faster and steeper than the recoveries that followed 1974 or 2002.

Most importantly, while we do not necessarily agree with Mr. Blodgett's demand-side arguments, or with his pessimistic conclusion, we would point out that we have also sounded a note of caution for investors going forward, based on the likelihood of both higher taxes and greater government intrusion into business activities in years ahead.

Most tellingly, in a post from this February entitled "Return of the 1970s, part 2," we said that:

"It is quite possible that the markets will snap upward with startling velocity when the current banking crisis is resolved. We believe that mark-to-market accounting continues to play a major role in holding the financial system hostage, as we have discussed several times previously (for instance here, here, and here). Repeal or even temporary suspension of the rule may well serve to ignite such a rally." That prediction was borne out less than three weeks later, when mark-to-market accounting was modified and the market began the rally depicted in the chart above.

However, in that same post, we noted that the 1970s demonstrated that just owning "the market" or the "Nifty Fifty" (an idea that held sway in the 1960s) did not work in all economic environments. While there was an impressive rebound after the 1973-1974 bear market, the rest of the decade was a clear example of the lesson that "during more economically challenging periods, where growth is harder to come by, the same larger companies can generally tread water, and selection of well-run companies involved in some kind of business paradigm shift can become much more important."

It is very possible that Mr. Blodgett's prediction of "treading water" may come true for the overall market, particularly if some of the anti-business mistakes of the 1970s -- such as price controls, wage controls, high taxes, and an inflationary monetary policy -- are repeated in years ahead. In such an environment, many companies may just bob along within a fairly stagnant economy, which is why that February blog post emphasized the critical importance of looking for those rare companies positioned in front of innovative growth fields.

While we do not agree that the recent run-up was just a "sucker's rally" (and we would caution that some pullbacks or "backing and filling" is normal and healthy after a strong move upwards), we do believe that investors should be concerned about a period in which the broad market may go back to "treading water" -- not necessarily right away, but after the market has finally recovered from its irrational panic.

Our advice for those concerned about such a scenario is to be sure to own growth companies in the equity portion of your portfolio, and not "the entire market."

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For later posts on this same subject, see also:


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