MDCigan

Why U.S. Stocks Can Move Higher in 2007 - Part I

Interesting article, and certainly food for thought. In your summary section, you list some "bogusss" arguments without refuting them. Simply listing them doesn't make them invalid. FWIW, I think I know who you are taking a shot at with some of those (peak earnings and earnings mean reversion). Suffice it to say, I've found the arguments for those particular items compelling and supported by the historical data.

I think somewhere else you made the point that a good model has to be both descriptive and prescriptive. Otherwise, what's the point? Far too many strategists offer opinions based on notions/models that may have zero support in the historical data. One thing I think is important to note is to distinguish the ***TIME FRAME*** of the model.

You say "It is our conclusion that stocks can move much higher during 2007." It is a COMPLETELY DIFFERENT FORECAST to say what stocks may do over a 1-year time frame versus what the likely 5-10 year returns might be. If you carefully read the research which uses the concepts of peak earnings, earnings mean reversion, peak P/E ratios, you will note the conclusions refer to the probable 5-10 year returns and not what the market may or may not do in a single year.

Just use 1998-present as an example. There have been a couple of really good years, 1998,1999, 2003, 2006. Yet the cumulative return over the entire time frame for the S&P 500 has been pretty poor. One was better off in T-bills. I am somewhat skeptical of models that try to forecast 1-year returns for the market. From year to year, the market probably trades more on technicals and sentiment then anything else, and fundamental valuation asserts itself over long time frames such as 5-10 years (voting machine in the short-term and weighing machine in the long-term). 2007 may very well be a strong up-year for the S&P 500 with the cumulative 5-10 year forward return being mediocre to poor.

"Some assert that the market has gotten ahead of fundamentals, since stocks have advanced more than recent earnings growth. These analysts are focused on what we call "local efficiency." They are assuming that last year's pricing was an accurate valuation.

In fact, stocks have lagged during a multi-year period where profits grew at double-digit rates.

There is a lot of catching up to do."

This is certainly possible, but it seems to me what could just as easily argue that stocks began this multi-year profit run at more expensive valuation levels then at previous troughs in the business cycle and therefore it is no surprise stock prices have lagged profit growth. Perhaps, there is not catching up to do, but just further multiple contraction. Exactly what time frame is it that the stock market gains should exactly match profit growth?

"Our own preview of 2007 informed investors that market valuations were low when one took the current low interest rates into consideration. Those who ignore interest rates in their analysis of fundamentals are adopting a method that we find distinctly inferior."

I struggle with this one myself. I think strong theoretical arguments can be made both ways for including and ignoring interest rates. The question has to be asked though why didn't low interest rates matter in the 40s, 50s, or much of the 60s in terms of higher P/E ratios. What data from what time period are you going to include in building your model? And if you are going to ignore certain time periods, then why? And where to do you draw the line? 10 years, 20 years, 50 years, 100 years?

I look forward to any additional articles from you. I am not dogmatic, or a perma-bear, and would love to see a persuasive case supported by the data to be very bullish over the next 5-10 years and not just for a single year. But I think you are going to have to carefully examine and refute some of the arguments you list as bogusss.