Saturday, September 15, 2012

The Bull/Bear Debate - And - The real hazard going forward

It's hard to believe that while Europe remains a long way from getting its house in order, while U.S. 'headline' unemployment stays above 8%, while the U.S. borrows a trillion and a half a year just to pay its bills, and while the U.S. is heading full steam toward a "fiscal cliff" (tax increases, budget cuts, etc.), the Dow sits just a few hundred points shy of its all-time high.

Skeptics (bears) tell us there's no fundamental justification for it. That the market has been bid up on nothing more than the prospects for easy monetary policy as far as the eye can see. That, given all that I outlined above, there's another crash a coming.

Before I make the bulls' case, I'd like to point out that when the high profile "expert" arranges his (and his clients') portfolios to exploit a bear market, and there's no bear in sight, he ends up getting mauled. The media, allowing bears and bulls equal time, provides him the platform on which to try and sway investors to his way of thinking. That is, to convince them to sell, and thus preserve his career. And by the looks of the cash allocation in your average portfolio (a record 69% as of July 31), he's, thus far, made his case (at least in terms of keeping investors from diving in). But therein lies his problem. Because of this average allocation to cash, earning nothing, while stocks are on the rise, he's in all-out panic-mode. If cans get kicked further into the future (Europe's kicking it hard as we speak. And the likelihood of U.S. politicians tossing their political careers off the fiscal cliff is exceedingly low), thus inspiring that cash to rush to stocks, Dr. Doom is doomed.

And of course the same (the attempts to sway the public) goes for high profile bulls.

The bulls tell us that the fundamentals are compelling: That stocks, relative to earnings, are far from over-priced. That corporate balance sheets look their best ever. That liquidity is off the charts. And that interest rates are ridiculously low. And don't sweat the geo-political stuff, without it, stocks would not be this attractive. Pessimism is therefore a beautiful thing.

But how can stocks be cheap when their pushing all-time highs? It's not about the price per share, say the bulls, it's about the earnings relative to the price per share (in an historic context). You see the cumulative earnings of the companies comprising the S&P 500 (according to Bloomberg and S&P) came in at $51.68/share when the index hit 1,469 back in 1999. 2012's earnings look to be coming in north of $100/share, while, as we speak, the S&P sits at 1,466. Therefore, if we use '99 as our benchmark for over-valuation, matching it would take the S&P to 2,940 and the Dow to 27,000.

(Now wouldn't that be something? Yes, something to sell like mad!)

As you can see, while the stock indices flirt with their historic nominal highs, they're no where near their historic valuation highs. And that's what the bulls say we should focus on.

So then, BUY BUY BUY!! Right? Well..... not so fast. We have 2007 to talk about. In '07, when the S&P hit 1,468, its earnings came in at $87.72 per share, which represents a price to earnings ratio (p/e) of 16.73. An historically reasonable multiple, and no where near the lofty 28.42 p/e of 1999. And you know what happened between the fall of '07 and the spring of '09? The S&P plunged to 660. So yes, the bears indeed have something to chew on. Stock prices can tank even when valuations would suggest they shouldn't.

So now we're left to compare 2007, with its reasonable 16.73 p/e, and 2012, with its (estimated) compelling 14.37. If the bears have it right, and we indeed experience an unprecedented second epic bear market (of equal measure) in four years - using purely the p/e as our measure of value (it plunged to 10 in '09), we're looking at roughly a 30% hit to the S&P 500. However, stock prices in '07 fell further than did earnings. The S&P p/e took a 40% hit between '07 and '09, while the index itself dropped 55%. Therefore, to precisely match that decline, today's S&P would take a 41% hit (i.e.,137% of the decline in earnings).

Now hold on a minute, cry the bulls. In 2007 the real estate market was busting at the seams. Wall Street had gone wild on mortgage backed derivatives. The consumer was living in debt-ridden lalaland. Corporate balance sheets were no where near as healthy as they are today. Interest rates were much higher, and everyone was fully invested (remember portfolio cash sits today at a record 69%). Comparing today with '07 is like comparing green apples with over-ripe oranges. Sure, geo politics can still get screwy, but the corporate sector is in tip-top shape. While in 2007 it was fat, dumb and lazy. If the market takes an '07-'09 style hit, it'll be the buying opportunity of all time. Which again, following the most recent all-time buying opportunity by a mere four years, would be an unprecedented, and unlikely, event.

Now, all that said, I do believe in black swans. Those unannounced, unpredictable events that Nasim Taleb (author of bestsellers The Black Swan and Fooled by Randomness [two books I highly recommend]) says shape the world we live in. But the fact that we're talking about the potential for a near-term major decline in stocks disqualifies it entirely. Not that it won't happen, it just won't be a black swan - since so many are predicting it.

So I'll leave you today with this observation: The things we see coming, like the Euro Debt Crisis and the "fiscal cliff" are typically not the things that deliver long-term "negative" consequences. It's the events we don't see coming, like Lehman's collapse (the market was certain it'd be bailed out) and the bursting of the dotcom bubble that tend to provoke those phenomenal buying opportunities (market crashes). The real hazard facing us going forward (the makings of future black swans) is of the moral variety: the government's habit of rewarding bad behavior. I'll have more on that to come...

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