'This Time It's Different': The Bull and Bear Case

Includes: DIA, QQQ, SPY
by: Nicholas Vardy, CFA

As the S&P 500 flirted with its psychologically important highs of March 2000, the bulls in the stock market have been partying like it's 1999. Now, seven years of relative famine after the great bull market of the 1990s thudded to a halt, a small group of seasoned investors believe that the real bull market has just started. The recovery in the U.S. market has been impressive. The S&P 500 is up 25% since last June and it has surged 96% since bottoming in October 2002. The Dow industrials returned to record territory last October. Only the NASDAQ would have to nearly double to return to its old record.

Positive sentiment abounds. Vernon Smith, a Nobel Laureate economist, is putting his money into biotech start-ups. Jeremy Siegel, of the University of Pennsylvania's Wharton School, asserts risk premium for stocks has fallen and that stocks should be valued 25% higher than today's levels. Louise Yamada, the former head of technical research at Citigroup's brokerage arm, forecasted the Dow climbing to 16,000 and ominously summed the bulls' sentiment in a recent issue of the Wall Street Journal: "[i]t really is different this time."

"This Time it's Different": The Bull Case

Bull markets typically last three or four years. That means the current bull should be on its last legs. But here's why the optimists believe that the current bull is a reprise of the roaring 1950s or 1990s -- a decade-long bull market that is supposed to be a once-in-a-generation event. Economic slowdown notwithstanding, the U.S. economy is still growing, since the Fed successfully engineered an economic "soft landing." Fundamental shifts in the global economy mean that the United States is no longer the only economic game in town. Global economies are growing faster than ever before. And that applies not only to China and India, but also to Western Europe, Latin America, Asia -- and yes, even Africa. The strong global economy has both kept the U.S. economy out of recession and boosted U.S. companies' profits. That's why every time stocks begin to slide, low worldwide interest rates, tame inflation and strong profits bring stocks roaring back.

Bulls point out that the S&P 500's return to record territory has merely retraced old ground. Over the past seven years, stock prices have risen less rapidly than corporate profits. That means the price of the overall market actually has fallen since 2000. In 2002, the S&P traded at a multiple of 46. Today, the market is valued just a little above its historic average -- about 18 times trailing earnings. That's not much above the post-war average P/E of 16.

Yamada compares the global expansion now with the United States after World War II, when America built roads, bridges and factories in the peacetime victory boom. Today's global build-out corresponds to the U.S. build-out from 1942 to 1966. Arguably, three billion new capitalists unleashed in the global economy will spur a bigger boom than 200 million Americans ever did. It's a New Era.

"This Time it's Different": The Bear Case

All this talk about a "New Era" gives market historians the shivers. Nobel Laureate Vernon Smith's pronouncements remind them of Yale economist Irving Fisher, who is best remembered for his observation shortly before the 1929 crash: "Stock prices have reached what looks like a permanently high plateau."

Yale professor Robert Shiller, author of "Irrational Exuberance" -- a book about the 1990s stock bubble -- is not about to be stuck with the same historical millstone around his neck. Schiller believes that the record profit growth and rock-bottom interest rates are overdue in reverting to average historical levels. Bullish investors like Ms. Yamada are naive to extrapolate bullish trends far into the future. Recall James Glassman's embarrassing commentary in the Wall Street Journal in March 1999 about how high the market will go? "A perfectly reasonable level for the Dow would be 36,000 -- tomorrow, not 10 or 20 years from now," he wrote.

And today's financial system is fraught with unknowns. Since the S&P was last at a high, derivative instruments have changed the investment landscape -- with hedge funds and private equity funds rivaling the influence of banks. Easy money put into private equity funds has triggered a collapse in the standards used to fund deals. Throw in the asset price bubbles around the world -- in Chinese stocks and in real estate around the globe -- and the way down looks awfully steep.

"The Financial Memory Is Very Short"

It wasn't that long ago that my business partner in a hedge fund -- the head of a U.K. financial firm -- was calling conditions in the City of London the worst he had seen since the early 1970s. As recently as four years ago, the financial world was still wracked in the throes of the dotcom crash and post 9/11 funk. Today's boom was built on the ruins of the worst bear market for the Dow industrials since the 1970s, and the worst for the S&P 500 since the Depression.

Nobel Prize winners are no better than the next guy in predicting the market's short-term direction. With apologies to Tolstoy, "Happy markets are all alike. Every unhappy market is unhappy in its own way." What will put an end to this bull market will be what my friend Nassim Taleb calls a Black Swan -- something totally unexpected and out of the blue such as a major war or natural disaster.

Until then, Cassandras will have it tough. Alan Greenspan made his famous "irrational exuberance" speech in December 1996. And the markets didn't reach their peak until March 2000. As John Maynard Keynes observed, "The market can stay irrational longer than you can stay solvent."