Monday, October 28, 2013

Wishful Thinking...

That the present bull market in stocks is chiefly the result of ultra-easy monetary policy is a most popular presumption these days. An ever-increasing supply of money chasing a finite supply of tradable stocks results in higher share prices, or so the story goes. And, thus---since any tapering of quantitative easing (QE) has been placed on indefinite hold---I'm sensing a great deal of optimism of late. And that, frankly, makes a wee bit near-term nervous.

Not that I necessarily agree with the premise that the Fed deserves all the credit for the present bull run: since the days of QE1, the aggregate earnings for the S&P 500 index have roughly doubled---so unless the Fed is to be credited with creating corporate profits, as I suspect some naysayers would, there's more to the story.

Those who dig below the surface (beyond QE) design legitimate-sounding arguments for where the market goes from here. Let's explore a few of those arguments:

The Bear Cases:

The bears (the present minority) tell us that the quality of earnings stinks. That recent earnings gains are the product of all the cost cutting that occurred as a result of the 2008 recession. That top-line (revenue) growth just hasn't materialized, and given that you can only cut so much---and that there's no sign of substantial GDP growth on the horizon---bottom-line growth is on the verge of stalling. And when missed expectations meet with record-high stock prices, look out below. The bears also make a convincing QE case: We saw the market sell off (albeit modestly) earlier this year on the mere hint that the Fed might "taper" in the coming months. Therefore, when they finally do begin cutting back those bond purchases---and dealing with that bloated balance sheet---look out below. And lastly (for the sake of this essay [there are yet more bear cases being made]), the bears are not at all accepting of the notion that stocks are reasonably valued based on next year's projected earnings. For one, as I stated, they expect earnings growth to stall and, therefore, they don't believe the estimates. For another, many prefer to focus on recently Nobel-crowned Robert Shilller's "Cyclically-Adjusted Price/Earnings Ratio" or CAPE. Shiller's formula, which averages earnings over a ten-year time frame, assigns the S&P 500 a current price to earnings ratio of 24.95. That makes the S&P roughly 57% more expensive than where I value it based on next year's projections.

The Bull Cases:

The bulls tell us that the global economy will see a pick up in the coming months and, therefore, the now-leaner companies whose stocks trade on the major exchanges will see their earnings beat expectations and their share prices propelled further into record territory. They see capital investment, stock buy-backs, mergers, and acquisitions increasing as businesses finally capitulate under the weight of their hefty cash positions. They see the, till now, stubborn holders of treasuries giving way to their greed and hopping onto the stock market bandwagon. They see desperate hedge fund managers, having, this year, grossly underperformed the major averages, abandoning their short positions and going long in a big way. They believe stocks are not only reasonably priced at 15.6 times next-year's earnings, they contend that, when you factor in current interest rates, stocks are way undervalued. And lastly (for the sake of this essay [yes, the bulls have more to tout]), the bulls see the Bernanke (soon to be Yellen) put (as in "put option", or protection) very much in place (a la paragraph 1) for the foreseeable future.

My Case:

I have no near-term bull or bear case to make, or support. Both camps have merit---but that's always my position. I came to the conclusion long ago that, when it comes to investing---and advising---humility is the most valuable commodity. A strong directional conviction can literally ruin a portfolio: Buy the bear case and abandon your long-term strategy (sell your stocks), and you can blow an unrecoverable hole in your portfolio, I've seen it happen. Buy the bull case and abandon your long-term strategy (sell your fixed income assets), and you can, well, just imagine how you'd feel if the bears have it right---and, yes, I've seen it happen. The thing is folks, the bulls and the bears, as educated, as calculating, and as convincing as they may be, are stabbing in the dark. They simply cannot know the near-term future. As for the long-term, make no mistake, they're both right; as John Templeton said, "we will always have bull markets followed by bear markets followed by bull markets."

All that said, I would sure like to see the bears win an inning or two sometime soon. I mentioned above that I'm feeling a wee bit near-term nervous; honestly, that was for effect. I am a little nervous, but in a good way (like I said, I'd like to see the bears win one). That's because the sentiment surveys of late are showing a huge tilt to bullishness. And I'm having to dig a little deeper into my sources to find out what the bears are thinking these days. And margin debt (folks borrowing against their stocks to buy more stocks) is on the rise, big time. Essentially, the investment world's glasses are decidedly rose-colored---and, like John Templeton ("bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria"), I'm a contrarian at heart. I like market corrections, they inject reality into the nervous systems of investors and traders, they "correct" for near-term excesses. I like buying stocks when we rebalance client portfolios. For over two years now, other than rotating a bit between sectors, we've been sellers (back to our clients' equity targets)---and that's a long-time without a meaningful correction. And while I won't go so far here as to label current sentiment euphoric---and I am in no way making a near-term prediction (call it wishful thinking)---it'd be nice for a good healthy correction to knock the optimists down a peg or two, keeping euphoria on the back burner for the time being.

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