The Current Equity Market Funk - Not A Normal Bear Market!

[ed]

But the worst is probably still to come

Quite.

rgds, ed

[Lambertus de Boer]

The longer you play, the more you lose
Andrew Smithers Sunday Times May 16, 2004

Andrew Smithers, king of the bears, says holding shares in today’s climate is as foolish as hoping for a big win at roulette — you won’t win in the long run

UNLIKE most articles about investment, which tell people how to make money, this one will try to persuade you not to lose it. Shares, bonds and property are all overpriced and even more recondite things such as gold seem to lack appeal. Cash is the thing to hold and we are lucky in Britain that money on deposit gives a decent return. This is a rather negative view, but please blame the markets rather than me.

The problem with investing in shares is that the rewards fluctuate hugely, not just from one year to another, but over decades. Long periods of high returns can be obtained only if shares become thoroughly overvalued and they are inevitably followed by long periods of poor returns.

We are in the early years of one of these poor periods. Chart 1 shows the story of equity investment in America. For the 30 years up to the end of the millennium, returns were wonderful and even after the subsequent falls they have still been extremely high for long-term investors. Starting with any year you like from 1973 to 1993, shares have performed well above their long-term average. They have typically gained about 10% in real terms — more than three percentage points above the 100-year average.

The position is not so extreme for Britain, where shares are less expensive, but this is only a moderate consolation as the British market seems to follow America’s.

Unfortunately, good news about the past is bad news for the future. Stock-market returns don’t follow a random pattern, like tossing a coin. Good times are followed by bad ones and vice versa.

If you play roulette, the chances of red coming up on the next spin of the wheel are never influenced by the number of times red has come up recently. Stock markets are different; the past is a guide to the future. But it’s not much of a guide for the short term.

Investing in overvalued stock markets is like playing roulette — the longer you play, the more certain you are to lose money. Although the odds against you on each spin of the wheel are small, over time this small disadvantage turns into a near certainty of loss. Investors who hold shares today may make money in the next 12 months, but the chances are that most of them will lose. Over the next five years the odds will worsen.

Because markets give poor returns after periods of good ones, it follows that they can be valued. There are two correct but different ways in which this can be done. The two correct ways track each other closely, as they would with any valid measure of value. (There are a lot of incorrect ways to value the stock market. These tend to be popular with stockbrokers, who like to pretend that shares are always worth buying.)

The two ways of valuing stock markets are based on two different approaches. One, using the so-called Q ratio, depends on the fundamental value of companies in aggregate being the same as the value of their assets, after deducting their debts. (This is not the same as their book value because allowance must be made for inflation.) The other method depends on shares’ earning power. It is based on the price-earnings (p/e) ratio, but allows for the fact that in the short term earnings can fluctuate dramatically.

Because earnings can go up and down so sharply, you cannot use this year’s p/e ratio to value the market. A great example of this is 1932, when in p/e terms the market was probably at its most expensive ever, because profits were so depressed, but it was also about the best year to buy shares.

Using the Q ratio or the cyclically adjusted p/e, and looking at either the American or British stock market, the most optimistic conclusion is that shares are about 45% overvalued.

If shares offer poor returns, bonds are one of the other options. Sadly, their prospects are not very good either. Government bonds yield some 4.5% in America and 5% in Britain.

Because the Bank of England is aiming at an inflation rate of about 2% a year, this suggests that the real return — after allowing for rising prices — will be in the 3% region. This is a little on the low side, particularly when the budget deficit is so high and the economy appears to have little spare capacity.

There is a high chance that the Bank will push up short-term interest rates, and when this happens bond prices are far more likely to fall than rise.

Bond yields now are not much better than the return on cash, which has the added advantage that your investment cannot go down in price. As equity markets usually overshoot when they are falling, there is a strong chance they will move from being overvalued today to being significantly undervalued in a few years. If Wall Street fell by a third, it would be fairly valued, but on past experience it could easily become undervalued and fall to half today’s level. Having cash to invest then will be a great advantage.

As the prospects for shares and bonds are bad, some British investors might be tempted by property, and it certainly looks as if house prices are headed up again this year. But this may be just as dangerous.

The value of Britain’s housing stock as a proportion of GDP has probably never been as high as it is today. The last time things were as out of line as they are now was in 1973, when we had the secondary banking crisis.

When markets fall, economic conditions will be worse than they are at present. Shares are more likely to be overvalued when things look good, but this will have almost no impact on their value. The frequently heard view that shares are good value because the economy is in good shape is nonsense. It doesn’t necessarily follow that good times go with overvalued shares and bad times with cheap ones, but it is more often true than the other way round.

World stock markets have been weak recently. Nobody can be sure why this has happened. However, it seems that investors fear we are coming to the end of the era of being able to borrow American dollars at exceptionally low rates. This worry is fully justified, but it does not mean that stock markets will continue to decline in the short term. Indeed, the decline may now fuel speculation that interest rates will not go up in a hurry. Equally, fashion may decide that now is the time to get out.

What we know is that the markets are overvalued; what we don’t know is whether the next spin of the roulette wheel will turn up red, black or even green, the bad “one in 37” chance, when nearly all the punters lose.

The writer is the founder and chairman of Smithers & Co, which advises leading fund-management companies worldwide on asset allocation

[sandid]

Maybe the gloomsters have got it wrong
- David Schwartz
Sunday May 16, 2004
The Observer
http://observer.guardian.co.uk/busin...217700,00.html

Doom and gloom headlines triggered by recent stock market declines seem a bit over the top.

Oil prices have remained within a steadily rising channel over the past year. Each visit to the top was soon followed by a short-lived sell-off. Each drop to the bottom triggered a rapid rebound. Recent declines, including last Monday's 103-point drop on the FTSE 100, moved the index toward the bottom of the channel. If the past is any guide, prices will soon bounce back up.

Some commentators do not agree. They believe recent dips are an early warning signal that the year-old bull market might be over. Many of these negative views don't bear close examination.

Least credible of all are the opinions of technical analysts who forecast future price swings from nuances in past fluctuations. Analysts are concerned that broad market indices are approaching their 200-day moving average, currently in the area of 4330 on the FTSE-100. According to charting theory, a break below this level could be the start of a very big fall.

The simple truth is that breaks below a 200-day moving average provide little insight into the future. Major continuation drops occasionally do follow such dips. On the other hand, quick reversals or aimless sideways price drifts are just as likely.

There is good reason to explain why most chart-based forecasts these days are dominated by words such as 'if', 'maybe' and 'perhaps'. History teaches that predicting a sharp follow-up decline in the aftermath of a fall below a 200-day average is about as accurate as predicting next Sunday's weather from today's peak temperature reading.

Economic arguments that the bull market of 2003-2004 is over have a greater ring of truth. But a more detailed analysis finds them to be full of holes as well.

Take the interest rate argument. Investors throughout the world have been concerned for several weeks about prospects for US interest rate tightening. Most would agree that a one-off move of a quarter or half per cent would probably have little effect on shares. The big fear is that a steady series of increases could affect interest rates in other countries including our own, slow down worldwide economic growth and be especially damaging to domestic companies that trade with America.

There is a major flaw in this argument. The Fed told investors it would respond to improved economic conditions in a measured fashion. This implies rates will rise as the economy improves. On the other hand, the statement also implies there is little to fear on the interest rate front if the economy fails to improve. In other words, rising interest rates and improved corporate profits should march hand-in-hand. This is hardly the recipe for a major stock market decline.

The real interest rate problem is a short-term one. US speculators were able to borrow at extremely low levels and invested those funds in speculative areas. The Fed's recent announcement caused these borrowers to retrench. Given the huge gap between current interest rates and the 3 per cent level that many commentators believe to be realistic, speculators had good reason to act in haste. Part of the recent stock market decline can be attributed to this retrenchment.

Oil's spike to $40 per barrel is also worrying investors. According to the bears, high oil prices can bring down the world's economy, as we saw in the mid-1970s. This argument is deeply flawed. Recall that oil prices rose five-fold within a year in the mid-1970s. British inflation was in the double digits and rising. It eventually peaked at about 25 per cent. The Opec cartel compounded the problems with supply cutbacks in order to maintain high prices.

There can be no doubt that high-priced oil has the ability to slow worldwide economic growth. But history suggests a 20 or 30 per cent gain from levels seen a few months ago will not cause a huge stock market collapse.

[Lambertus de Boer]

Market Commentators, David Schwartz and Andrew Smithers, authors of items in the last two posts are like blind men trying to determine what kind of beast they have in front of them.

Schwartz is looking at the short game and smells the elephant and feels the more important body parts to sense that the beast remains in estrus and suggests staying out of the way for any erswhile bulls coming to service the account.

Smithers has been around the game a lot longer and looks at the long game. Schwartz also smells the elephant and is familiar with the low rumble noises it is making. Schwartz has seen estrus besieged elephants come and go. While there may be a few good romps left in the old lady, she is old, tired and may well be prone to roll over giving in to its last leggs.

Originally posted by Lambertus de Boer
Market Commentators, David Schwartz and Andrew Smithers, authors of items in the last two posts are like blind men trying to determine what kind of beast they have in front of them.

Schwartz is looking at the short game and smells the elephant and feels the more important body parts to sense that the beast remains in estrus and suggests staying out of the way for any erswhile bulls coming to service the account.

Smithers has been around the game a lot longer and looks at the long game. Schwartz also smells the elephant and is familiar with the low rumble noises it is making. Schwartz has seen estrus besieged elephants come and go. While there may be a few good romps left in the old lady, she is old, tired and may well be prone to roll over giving in to its last leggs.

[sandid]

Or perhaps they can both only see through different, small holes in the blanket of uncertainty. Schwartz sees a beautiful, blinking, brown eye with long eye-lashes. Smithers is looking at the sh*tty end.

[Lambertus de Boer]

Originally posted by Value Investor

VI

I must admit that I wrote this without benefit of drink or unsolicited advice from John van der Mark. The point of the exercise was to suggest that overall equity market valuations continue to be excessive, a hangover of the "ramp-up" experience of the nineties and the post WW II period generally. Equity markets will continue on the backside of this experience for some time to come.

Though, I do admit to liking the Sandid theory. One big brown eye in your eye, Sandid!

[J. van der Mark]

Don't blame me, Bert...

Those elephants...do you keep them as pets?

I intend to add an ostrich to Bert's two house pets...

Do you know...I'm half afraid to look at my depleted portfolio - where's it going to end?

I mean, the general outlook is good...the experts reckon that it's the punters that have borrowed money are the ones cutting and running, therefore depleting the market

John v

[sandid]

A good assessment by Anatole in The Times on Tuesday: Economic View - The Asian decade can't be written off just yet

[ed]

Re. The worst is yet to come etc....

I went short the Dow today & intend to add to my position as it declines. Looking nasty everywhere I think.

Rgds, ed

[Scientist]

Originally posted by ed
Looking nasty everywhere I think.

I know

Yours,

Scientist

[ed]

Yes, you're looking particularly nasty today Scientist... although maybe that's just a stain on the webcam.

I was early on my short but think the US looking very overbought so will stick with it...

Rgds, ed

[Lambertus de Boer]

A Recovery Trying to Keep Its Legs Suddenly Feels Woozy
EDUARDO PORTER New York Times Business Section Published: July 12, 2004

Retail sales slowed in June. Auto purchases declined. Several technology companies warned about weak software and hardware spending at the end of the second quarter.

Less than three years since the United States emerged from a recession, a patchwork of unexpectedly soft economic reports is raising doubts about the vigor of the recovery.

"At every client meeting I have,'' said Ethan S. Harris, chief United States economist at Lehman Brothers, "I'm asked whether a slowdown has hit the U.S. economy."

Indeed, stock prices have faltered since the end of June, as corporate earnings have disappointed investors. And bond prices have risen, as evidence of economic fragility has allayed fears that inflation will accelerate. The recent sluggish economic indicators have inspired a note of caution in forecasts which until now had been unabashedly bullish.

"Economic data over the next several weeks are likely to follow the theme of slower growth with continued inflationary pressures," wrote Andrew Tilton, an Goldman Sachs economist, in a note to clients. "In addition to a weaker trend of consumer spending, we expect some modest deceleration in factory sector activity."

But, despite the scattered straws in the wind, most economists remain confident that economic growth is not collapsing but is shifting to a lower, more sustainable rate.

"The economy has come off its peak in the last couple of months," said Martin A. Regalia, chief economist at the United States Chamber of Commerce. "People have dropped their forecasts to about 3.5 percent. That's still a pretty solid number."

As the nation has rebounded from the recession of 2001, the main theme has been the ability of consumers to continue borrowing and spending. Near record-low interest rates allowed homeowners to refinance their mortgages, taking money out of their homes to pay for renovations and all sorts of consumer durables. Dirt-low interest rates allowed auto companies and others to offer zero interest-rate loans to stimulate sales.

Eventually, this dynamic was expected to end, as the recovery took hold and interest rates started rising. But even as debt-financed consumption waned, most economists expected two new sources of growth to kick in. First, a rising number of jobs would increase the overall wage pie - helping maintain consumer spending. Second, businesses, which spent the earlier part of the recovery paying down the debt amassed during the dot-com boom, would again start investing in new equipment.

Rising oil prices, however, have complicated this switch. Spurring a jump in inflation and taking a big bite out of the wallets of consumers, rising energy prices have raised the question of whether, combined with higher interest rates, they could depress consumer spending before the new sources of growth could gather sufficient steam.

Signs of the end of consumers' exuberance have popped up in several areas. Year-over-year growth in spending slowed to 4.1 percent in May, in real terms, the slowest pace since January. And there is anecdotal evidence of dreary sales in June. At Wal-Mart Stores Inc., the nation's largest retailer, sales climbed 2.2 percent in the last month, the smallest gain in over a year. At The Gap Inc., the clothing chain, comparable store sales in June actually fell 2 percent after several months of strong results.

June was also sour for automakers. The General Motors Corporation reported sales that fell 15 percent and the Ford Motor Company reported an 8 percent drop from the same month a year earlier. Citing the "difficult new vehicle retail environment that we are operating in," AutoNation Inc., America's largest automotive retailer, trimmed its earnings forecasts for the second quarter.

The corporate sector has also shown some fragility. Business investment had perked up this year after being absent during much of the earlier recovery. But in the second quarter, corporate investment seemed to fall back.

New orders of nondefense capital goods, excluding aircraft, fell 2.1 percent in April and 3.5 percent in May. And business spending on technology has seemingly remained weak. Since the beginning of July, 32 technology companies have issued warnings of lower second-quarter profits, according to Thomson First Call, while only one has increased its earnings projections.

Against this weaker economic backdrop, the Labor Department's report of an abrupt slowdown in job creation last month, which was accompanied by a fall in the average number of hours in the workweek and a meager increase in hourly wages, raised a question mark over the standard account of the economy's evolution.

"Now the only real positive for the consumer is income and job growth," Mr. Harris at Lehman said. "If the labor market really slows down it would be a blow to the consumer and we could talk of growth slipping to below trend."

But it is still too early to make that call. Indeed, Mr. Harris and most Wall Street economists view the June employment report as an aberration, and believe job growth will return to a more robust growth trend in July. If this is true, the economic recovery might do fine. Other data foreshadowing emerging weakness might just be a function of the changing sources of economic growth; not a signal of its demise.

"We've gone from an economy on life support driven by super aggressive 'refi' to one driven by more traditional sources of consumer income, which are jobs,'' said Robert J. Barbera, chief economist at ITG/Hoenig. "In the transition, we may see a change in the sectors that do best.''

Many economic variables remain strong. Personal income, a major driver of consumer spending, is growing. Mortgage applications are still increasing. Home sales are at record levels. The Institute of Supply Management's Purchasing Managers Index - historically an accurate gauge of manufacturing activity - is indicating only a mild slowdown in the second half from a strong period of expansion in the first.

Moreover, with interest rates still near their all-time lows it is harder to build a case for a sudden economic retrenchment than to explain continued growth.

The economy "is firing on all cylinders and the structure of interest rates is still crazy easy," Mr. Barbera said. Given that backdrop, he added, "I'm willing to cast a blind eye to the past 30 days' data."

[Lambertus de Boer]

A Market Forecast Takes a Long View, and a Dismal One It Is
MARK HULBERT New York Times Business Section July 18, 2004

STRATEGIES

THE stock market in the summer of 2008 is likely to be only barely higher than it is today.

That disheartening prediction comes from a market-timing model with an excellent record of forecasting four-year stock market returns. The model is based on projections from analysts at Value Line for price changes over the next three to five years in the 1,700 stocks they monitor. The median of those projections is published each week in the Value Line Investment Survey.

Value Line doesn't advise investors about how to interpret this statistic. But since 1968, when Value Line began publishing it, low readings have generally been followed by mediocre stock market returns over the next four years. Similarly, high readings have typically been followed by above-average returns over similar periods.

To be sure, the Value Line numbers haven't been very accurate in forecasting short-term market moves. But they have been quite reliable in predicting the longer term.

They have proved particularly useful when the mood of investors reaches extremes of euphoria or despair. Value Line's median projection was last considered in this column on Sept. 30, 2001, less than three weeks after the terrorist attacks. At that writing, the indicator was at 105, its highest in more than a decade. At the time, many investors were unwilling to make any bets on the stock market, but those who relied on that high reading to invest in equities have been rewarded. The Standard & Poor's 500-stock index has produced a cumulative total return of 20 percent since Sept. 21, 2001, the day of the market's post-attack lows.

Unfortunately for market bulls, however, the Value Line reading has now sunk to 50, a very low level. Over the last 36 years, in fact, the reading has been lower just 11 percent of the time.

The indicator has limits, of course. It's hardly foolproof. And because it focuses on median performance, it is not helpful in projecting how large-capitalization stocks will perform relative to small caps. If the large caps lead the market over the next four years, indexes that are dominated by the large caps - like the S.& P. 500 - will do better than the indicator suggests.

Credit for realizing the indicator's market-timing power is shared by at least two people, who independently reported on its usefulness in the mid-1980's. The first is Daniel A. Seiver, an economics professor at Miami University in Ohio and the editor of the PAD System Report, an investment newsletter. The second is Peter L. Bernstein, the founding editor of The Journal of Portfolio Management and now the head of a consulting firm that bears his name.

Professor Seiver is so confident about the indicator's market-timing powers that he bases his newsletter's market-timing advice on it. He considers any reading of 100 or more to be a buy signal, for example, while he uses a reading of 50 or below as an occasion to build a large cash position in his model portfolio. Based on the current reading of 50, Professor Seiver is recommending being only 50 percent invested in stocks. And he says he will not advocate reinvesting any of that cash in the stock market until Value Line's median projection rises back to at least 100.

Professor Seiver says several factors help explain the indicator's usefulness. First, he says he finds that Value Line stock analysts tend to be "less susceptible to valuation manias" than most other analysts, because Value Line's are independent, immune from the pressures that can be found in research departments associated with investment banks and brokerage firms.

A second factor, he said, is that few other firms besides Value Line even bother to focus on what will happen in three to five years, concentrating instead on just the next 12 months. Because so few other analysts are looking so far ahead, Value Line's researchers should find it relatively easy to spot profit opportunities.

"Wall Street is certainly myopic," he said. "Anyone who is willing to focus on the longer term should be able to earn a bonus for doing so."

A third factor, Professor Seiver said, is the "law of large numbers," which holds that random errors become insignificant when focusing on many observations. He has no doubt that many Value Line projections of individual stocks' three-to-five year returns are wide of the mark. But because the median projection is the distillation of nearly 2,000 separate forecasts, he said, "the analysts' errors will tend to cancel each other out."

And for now, the overall forecast suggests that investors should not be too optimistic about the stock market.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of CBS MarketWatch. E-mail: strategy@nytimes.com.