Mercury Rising 鳯女

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The Bear Case

Posted by Charles II on March 15, 2010

This has been a nasty season to be a stock market bear. If you went short the market when it was at over-bought levels in mid-January, and held beyond when it drifted down 8%, you are now probably sitting on some unrealized losses (very soon to be realized if you had March options). If you bought after the peak, your losses (realized or not) are probably substantial. An August $18 put on the Bank of America purchased in mid-February at $3.90 is now at $2.22 (though this may also be because the fear of lawsuits is receding). Trading options is not for the faint of heart.

So, is there a reason to be optimistic on the market? Retail money has certainly been appropriately cautious, which is a good sign. When the lady at the diner is giving you stock tips on technology companies is the time to cash in. When she’s buying krugerrands and stocking up on basic grains, it’s probably a great time to buy stocks. There are also good reasons to discount the claims that portfolios are already very aggressive in stocks. M-1 and M-2, the best measures of liquidity, are at new highs. That means that there is a lot of money sloshing around checking accounts, if not actually under the mattress. Nor should the very large sums of bad commercial real estate mortgages and prime mortgages be too off-setting. The system has already worked off almost two years of elevated defaults. While that means maybe 3-5 years to go before they start to approach normal levels, the kind of mindless fear that drives panics is now bounded by a more definite sense of the size of the crisis.

But there are a lot of reasons to believe that there is at least one more leg to the bear market. First is valuation.


(Source of image: http://www.multpl.com).

What this shows is that while valuations are not as ridiculous as they were in 1929 or 2000 or even 2008, they are still at or above the levels at which the bad market of the 1970s ensued and well above the median. Now, if profits go up, which can happen for any number of reasons, perhaps the valuations will fall without prices following. But at the very least, the likelihood that prices are likely to be at best flat is one key point to be aware of.

A second, which one can find at a chart on the same site is that dividends are near historically low levels. Since inflation is low, real returns are better, but not better than many 2-year CDs. Cash generation is a critical issue, because it pays broker’s fees, taxes, and maybe even the bulldog. What these two facts imply is that people are being asked to buy stocks for minimal cash dividends and poor prospects of higher stock prices perhaps for years to come. Why not just keep the money in a safer form?

Today, David Rosenberg, who has been a bear for a long time, but is not a permabear, added a number of concerns that should weigh on investing decisions. The article is by free subscription:
Political risk (e.g., US-China trade conflict)
* Default risk (potential downgrade of US and UK debt)
* Consumer weakness (February retail sales, excluding gas and groceries are down, year on year)
* Small business credit conditions (reported to be worse than at any time in 25 years except spring 2009)
* The likelihood of rate hikes in countries like China, which are suffering inflationary pressures
* The ECRI Weekly Leading index has turned, indicating slower growth and consistent with the view that there will be a slowing in the second half.

income does not show a rebound, suggesting that growth is coming from savings. There’s also an impressive graph showing the collapse of unit labor costs. Employers love recessions:

Unit labor costs by Laurel Graefe, senior economic research analyst, and Jacob Smith, quantitative research analysis specialist, both at the Atlanta Fed (Image from Atlanta Fed)

Barry Ritholtz, on the other hand, draws attention to a real-time index of consumer demand by Consumer Metrics Institute which shows that although demand has been falling since October, it may have started to rebound.

My take: the bears will do better for the next six months.

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2 Responses to “The Bear Case”

  1. I’ve got a nice mix — I’m the bull, my spouse is the bear. The combination serves us well.

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