Bears are Smarter but Bulls Make More Money
11/15/06
Records exist so that they can be broken at some point in the future. So far, the year 2006 has seen several records broken that seemed unassailable just a mere 11 months ago. One of them is the 7 year old record of the Dow Jones Industrial Average, which climbed for six straight sessions, snagged its 18th record close since Oct. 1 and finished the week at 12,343. It rose 1.9% last week and 15% this year. The Standard & Poor's 500 reached a six-year peak at 1401, up 1.5% last week and 12% for the year. But small stocks shone the brightest. The Russell 2000 pushed to an all-time high midweek before finishing up 19, or 2.5%, at 788, putting its year-to-date gain at 17%. Meanwhile, the professional cast of money managers continues to be dumbfounded by the relentless advance. Most of them have joined the bull camp only recently and needed to be dragged into it kicking and screaming. Why is it that professionals have become so cynic that they can not believe a good thing when they see it? I know the temptation, God knows. Bears usually have the aura of being more realistic than the bulls have. Bears see all the pitfalls and potential landmines out there, whereas the bulls have no particular insight rather than their own rose colored glasses and their naïve optimistic disposition. Bears always sound intellectually superior to the bulls. Professional money managers make a living from sounding smart and intellectually superior and therefore seem to gravitate towards the bear camp more often. I am not saying that one should ignore the potential pitfalls or to ignore intellectual arguments. I am saying, however, that at this particular point in time, just as 11 months ago, the bulls still have powerful arguments.
Does this look exuberant to you?
The above picture was constructed using data from Standard & Poors. Since 2003, the S&P 500 climbed a Wall of Worry. Earnings of the 500 companies contained in that index climbed faster than their stock prices did. The result was falling price-earnings ratios in a rising stock market. Current PERs are cheaper than at any time during the last ten years. Count one for the bulls.
The picture above was lifted from Marc Faber’s
The Gloom, Boom & Doom Report, in which he deals with GaveKal Research new book "Our Brave New World". The book is a must read! The book explains that of the three corporate functions (design, produce, sell) the production part is the most capital intensive and volatile. Over the past 50 years, that portion of the economy (including the manufacturing jobs that go along with it) has been successfully outsourced to countries like Mexico, India or China. The result was not only the loss of those high-paying but notorious unstable manufacturing jobs but also (and more importantly???) the decline in employment volatility in this country. Today, the workforce in this country fluctuates less than at any other time. The outsourcing of volatile manufacturing has brought more stability, not less, if we can believe the authors. The result is that "...whenever underlying economic activity is weaker than had been forecast, Western companies do not end up with excess inventories, excess labor etc. It is the suppliers that have to deal with any excesses left over by the unforeseen economic softspot." Massive layoff's (like Ford just announced) happen in Mexico or China, not in the U.S. GaveKal research gives us also another bullish argument in the aforementioned paragraph. They say "A less volatile economic cycle is, needless to say, a great thing to have. It allows entrepreneurs to plan for the future more consistently, consumers to make decisions for the long term in the knowledge that they will not lose their jobs, governments to plan for fairly accurate tax receipts, companies to paint accurate pictures of future earnings to shareholders etc. All this, of course, means that the fall in the volatility of the economic cycle has consequences of its own."
This consequence is called leverage. Companies can borrow more and use their balance sheets more efficiently if they know that economic cycles are tamer than the proverbial boom or bust cycles of the "industrialized" 19th century. This ability to leverage against a known and more certain stream of income does not only extend to corporationS, consumers and governments, but it applies especially to hedge fund investors. Hedge funds can leverage their investments more if they know that volatility in asset prices (stocks, bonds, currencies) will be subdued.
The S&P 500 has not had a 10% correction in 4 years. The fall in volatility has made selling insurance against volatility extremely profitable. If nothing bad happens, you collect the premium. Recently, nothing really bad has happened so the selling of options, interest rate swaps, currency swaps and credit default swaps (CDS) proliferated. Each product is simply a type of insurance against something bad happening. Since Volatility has fallen in recent years, the average insurance premium has fallen with it. Institutions who want to garner the same returns as in previous years will have to sell more and more insurance. I have a suspicion that a flat yield curve is prompting someone somewhere to take on too much risk and that an extended period of stability is prompting folks to sell too much insurance against a return of (financial) instability. Still, as I described above, the fall in volatility has emboldened the bulls and the stock market has proven them right, so far. Count two for the bulls.
The chart above was last shown here on January 15, 2006 and depicts the Fed Model in graphic form. Eleven months later, the S&P 500 has risen by over 12% and the stock market resides in undervalued territory thanks to rising earnings and falling bond yields. Even though stocks are riskier than T-Bonds and although the Fed Model has inherent flaws, it has given us a good sense for valuation throughout the years. Count three for the bulls.
Even though it may be dangerous to consistently bet on a positive outcome throughout one's career, it is the bulls who had the upper hand for the last 4 years. Bet against the bulls at your own risk.
Milton Friedman died this week. I grew up thinking that this man was the devil incarnate. I even said so myself, believing the half-truths they spread about him and his followers. Chile’s mass-murderer Pinochet was said to have believed in Milton Friedman. Therefore, Milton Friedman must have believed in Pinochet, right? Wrong! His conviction that free markets work was used as an excuse by many crooks to exploit and pillage. Today, three decades later, I wished I could apologize to him in person. Since I can not do that, I am hereby apologizing to everyone. I usurped his persona for the ideological means of my day. You did not deserve that, Mr. Friedman. Rest in peace!
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
