Sell Siders Make the Bull and the Bear Case for the U.S. Market

Bear Stearns’ excellent economist David Malpass summarized the bull case after yesterday’s market meltdown…

World equity markets fell sharply on February 27. Most were down 2%-3%. We attribute this more to the speed of their advance in recent months than to anything new.

China’s sell-off valuation-related. We don’t think anything new is going on in China that would qualify as an inflection point.

No shift toward risk aversion. Outside sub-prime, credit spreads remain at very, very tight levels.

One of the key factors unsettling global markets in recent days has been concern over sub-prime mortgages. While problems here may continue, we don’t expect broad spillover.

We don’t see much similarity between current conditions and the stiff mid-May 2006 global sell-off. In our view, that sell-off was triggered by concern over rising inflation and possible Fed responses. Core CPI inflation had been high in February, March and April 2006 and Fed Chairman Bernanke was relatively new to his post then, adding a degree of uncertainty. While most asset prices are higher now, so are earnings and global economic gains. An important contrast with May 2006: core CPI inflation was low in October, November and December (though higher in January), and Bernanke enjoys a high degree of respect and confidence.

Those sentiments were echoed by Lehman Brother’s strategist Ian Scott…

Recent sharp declines in global equities are not, in our view, the beginning of either a bear

market, or a much bigger "correction". While there are signs of excess in some parts of the global market, we do not think the market as a whole is characterised by overly optimistic expectations. We retain our year-end targets: + 11% total return from current levels for global equities. We do not see the recent sharp falls in global equities as being the beginning of a major correction. Valuations and the continued low supply environment remain good fundamental supports for stocks. Earnings estimates, while no longer being upgraded, are not being cut. Investors are transitioning from a market driven higher by optimism about earnings and economic growth to one supported by valuations and strong corporate sector fundamentals. There are signs of excess in some areas: emerging markets, cyclical stocks we underweight both areas. Retail investors have been heavy buyers in recent weeks, which does suggest some "froth". In our judgement these signs of excess are not sufficient to undermine the low valuations and positive supply / demand positionWe reiterate overweights in Japanese stocks, Telecom, Tech, Media, Insurance, Healthcare and Energy sectors. Underweight Cyclicals, Banks, Consumer Staples and Utilities.

And by Citigroup’s Tobias Levkovish…

While a sharp sell-off in China has been blamed for a global equity market retrenchment, including a severe hit to US stock prices, we suspect that some pressure has been building for the past week or so. Tobias reckons that the sell-off was driven by a confluence of factors, generating a newfound fear that has overwhelmed prior skepticism. Various indicators suggest that things should calm down in the future such as the VIX, the ARMS index near record levels, a plunge in bullishness readings, and a rise in put/call ratios. Declines of greater than 3% in a day have generated an impressive record of market recovery with a near 80% investment success rate within three months. Accordingly, he believes that investors should be aggressive buyers of semiconductor stocks (due to likely capacity constraints and already weak estimate revision trends), retailers (due to valuation attraction and excessive consumer worry), telecom service stocks (given 6 impressive pricing power), and select energy stocks (integrated companies where valuation is compelling).

You get the point. It seems to me that complacency is alive and well even after a 3% smack-down.

On the other side of the equation, Punk Ziegel & Co's contrarian Richard Bove couldn't have summed up the bearish case any better after a rough day in the markets yesterday. He's the financial stock analyst but his comments are apropos of all stocks.

Liquidity was the one factor driving up asset prices and he argues that it is drying up...

The Issue Is Liquidity and It May Be Eroding

The core theory that has been driving my commentaries for the past few months is based on these falling dominos:

• Low interest rates, low labor costs, and increased globalization created an environment for sustainable economic growth.

• This, in turn, stimulated higher housing values and higher employment levels. These factors, augmented by record levels of borrowing, stimulated a surge in consumer spending.

• The trade deficit of the United States surged and this stimulated money supply growth worldwide.

• The growth in money supply was magnified (velocity increased) by improved technology resulting in a proliferation of new financial products.

• High profits were being generated in foreign companies, many of which were/are located in China. These profits attracted a surge in invested capital into a wide variety of companies.

• Too much money began to chase too few deals.

What Changed?

This environment changed here and abroad:

• Firms, rich in profits and invested capital, expanded capacity at record rates.

• In the United States, interest rates began to rise, labor tightened, and housing values began to fall. Income and wealth creation began to weaken.

• Holders of funds gave up their willingness to be paid for the risks being taken in deploying funds. Risk premiums evaporated.

• Underwriting of every type of financial instrument weakened appreciably. Sub-prime loans blew up at one end of the scale, while private equity funds pushed prices up to levels where cap rates virtually disappeared.

• Values in the debt capital market reached dot.com levels.

Consequently …

The present situation is fraught with risk for which no one is being compensated:

• There is excess capacity facing weakening demand.

• There are huge amounts of money invested in sectors where returns are inadequate.

My belief had been that the economy was at risk, the financial system was in danger, and the outlook for earnings in financial stocks was poor. However, I was willing to buy stocks because liquidity was so great that it would push financial asset values higher. Now, I am looking for places to cut back on holdings because it appears that liquidity is drying up. It is not advisable to jump while the market is panicking but once a sympathy rally develops, positions should be pruned.