16 Reasons To Be Bullish On This Market

Bond investors and value investors tend to be cautious in investing. It is possible to be too cautious, though, and so sometimes it pays to lay out the bull case.

Indirectly, I learned this after several years of sitting next to the high yield manager at Dwight Asset Management (a very good firm that few know about). He wasn’t unconcerned about negative developments, but knew that fewer bad things happen than get talked about, and that they tend to take longer to happen than most imagine. He knew that he had to take some risks, because if you wait for the market to correct before you enter, you will miss profits while waiting, and the correction could be a long time in coming.

Also, I fondly remember our weekly economic conference calls in 2002, where the high yield manager and I would take the bull side in the discussions. For me it was fun, because it was so unlike me (I tend to be a bear), and it helped me to learn to balance the risks, and be a perma-bull or a perma-bear.

So with that, here’s my quick list on what is going right in this environment:

1. Earnings yields are higher than bond yields, particularly among many investment grade companies, fostering buybacks and occasional LBOs. Profit margins may mean-revert eventually, but it might be a while for that to happen, given the global pressures that are keeping wage rates low.
2. The financing of the US current account deficit is still primarily being done through the purchase of US dollar denominated debt securities, keeping interest rates low in the US. This may shift if enough countries experience inflation from the buildup of US dollar reserves that they do not need, and allow their currencies to appreciate versus the US dollar. That hasn’t happened in size yet.
3. ECRI’s weekly leading index continues to make new highs.
4. Money supplies are growing rapidly around the world. Most of the paper is creating asset inflation, rather than goods inflation so far.
5. Bond yields have moderated since the yield peak in mid-June. Spreads on corporate investment grade debt have not widened much. Financing is cheap for the creditworthy.
6. Short sales are at a record at the NYSE. Part of that is just the influence of hedge funds.
7. Vulture investors have a lot of capital to deploy. Marginal assets are finding homes at prices that don’t involve too much of a haircut. (I’m not talking about subprime here.)
8. On a P/E basis, stocks are 45% cheaper than when the market peaked in March 2000.
9. Sell-side analysts are more bearish than they ever have been.
10. Investment grade companies still have a lot of cash sitting around. The washout from 2000-2002 made a lot of companies skittish, and led them to hold extra cash. Much of the cash has been deployed, but there is still more to go.
11. The FOMC is unlikely to tighten before it loosens.
12. Yield-seeking on the part of older investors is helping to keep interest rates low, and the prices of yield-sensitive stocks high.
13. DB Pension plans and endowments are still willing to make allocations to private equity.
14. The emerging markets countries are in aggregate in better fiscal shape than they ever have been.
15. Trade is now a global phenomenon, and not simply US/Europe/Japan-centric.
16. The current difficulties in subprime are likely to be localized in their effects, and a variety of hedge funds and fund-of-funds should get hit, but not do major damage to the financial system.

Now, behind each of these positives is a negative. (Every silver cloud has a dark lining?) What happens when these conditions shift? Profit margins fall, interest rates rise, inflation roars, risk appetites decrease, etc?

These are real risks, and I do not mean to minimize them. There are more risks as well that I haven’t mentioned. I continue to act as a nervous bull in this environment, making money where I can, and realizing that over a full cycle, my risk control disciplines will protect me in relative, but not absolute terms. So I play on, not knowing when a real disaster will strike.

Comments

[NutritionFacts:]

In general, I agree, although number 8 is a little adventurous methinks.
Bearishness is good. It makes me more confident as a bull.

2007 Jul 05 03:28 PM

[Jorge Piedr...:]

Earnings yield higher than bond yields.

Well that should always be the case as a fixed income instrument is significantly less risky than equity -- whether it is UST or AA paper. I am actually amazed how people are fixated with this.

Also, earnings are high on historical basis which basically says that it is unlikely that future growth will continue at the pace that the bulls are projecting -- otherwise people will end up working for free at some point.

In addition, UST yields are low due to a list of price insentitive buyers (i.e. central banks) most of which told us that tell will look for other assets and other currencies. The low end of the 10 year yield is now a solid 5%, with the potential to get close to 6% in an inflation uptick. And corporate spreads continue to widen -- just check swap spreads, ITraxx, or anything else including Emerging Markets.

The argument reads more like the new era we have heard many times in the past -- whether in 1929, 2000 or 2007...

2007 Jul 05 03:29 PM

[NutritionFacts:]

Who is saying that we are in a 'new era'?

2007 Jul 06 10:26 AM

[Robert Nabloid:]

I think #2 on your list could be extremely important in the future and its the one I'm most worried about.

2007 Jul 05 05:26 PM

[c1ue:]

Good list, but #2 makes #11 less likely.

With interest rates going up everywhere except the US and Japan, I am completely convinced that the Fed is more willing to risk a painful (but not imploding) housing market and sluggish economy vs. a truly significant dollar devaluation.

2007 Jul 06 10:53 AM

[Walter Morton:]

An interesting analysis, though IMHO overly focused on financial benchmarks. I appreciate that the Mr. Merkel concludes his post admitting “real risks” as opposed to financial measures, so I’ll list six realities that make me a “nervous” investor as well.

1. The USA is stuck in an expensive war on the far side of the globe costing more than $100 billion a year at present. It seems unlikely we will be able to withdraw for some years. We will emerge with a lot of debt.

2. There is growing evidence that world oil demand in permanently exceeding supply, and no technology on the drawing boards (wind, solar, fuel cell, etc.) offers the efficiency and versatility that cheap oil has provided for the last 75 years.

3. Atmospheric CO2 is currently measured at 383 parts per million, whether you believe in “Global Warming” is a liberal media buzz word or not, something measurably new is happening to global climate, and the physics of a higher CO2 atmosphere will probably have major impacts on agriculture and regional economies over the next 10-500 years.

4. Between 2002 and 2006, USA housing prices have increased 73% creating an 8 trillion dollar “housing bubble” perched on low interest, and no painless soft landing for people who’ve bought in at the top. The American myth of "own your own home as the best, safest investment" may come seriously undone.

5. In 2006, the trade deficit reached $760 billion (6% of USA GDP) due to an overvalued dollar, which has suppressed foreign consumption of USA-made products.

6. There is no evidence that political leadership and will-to-change is forming in the US congress to adequately address any of the previous 5 issues.

All that said, I am bullish that selected industries will profit even in troubled times and that the 6 "problems" I note above can also be investment opportunities, seen from the right perspective.

2007 Jul 06 12:04 PM

[Solution:]

Comment on 7/26/2007 : Stick to the 16 reasons and back up your truck, loaded with stocks.

2007 Jul 26 02:00 PM