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October 18, 2005

Reader mail accurately assesses my outlook, Mon., Oct. 17, 2005, 9:29 AM

Bill, Among analysts who are bearish now, your expectation, at least for the Dow, seems relatively sanguine -- more of a bear phase than bear market. Certainly your expectation is much milder than declines in most cycles.

Is this possibly in part because:

1) The Dow is full of large caps which a) are global and so less affected by problems in US and b) didn't get as overvalued as the Nasdaq by 2000 and already under-performed during this 3-year bull phase;
2) There is so much hedging now that large players have less need to sell underlyings than before -- their betas far exceed overall market volatility.
3) Public participation is less significant than historical norms and so overall market behavior is less volatile. Jack Bogle recently said that in the (long-ago?) past, public ownership was about 90% of the market, whereas it's now about 30%. Bernie Schaffer, though, often notes that short interest on Dow components is very low -- but maybe put-buying rebalances that indication of over-optimism?
4) PE ratios across the US market have already contracted significantly in the trading range environment that started Jan 2004, so a bear market needn't go too far down or last too long. And if the decline to July & Oct 2002 was way overdone, then the Summer 2003 top is technically sensible support.
5) The Economist notes that U.S. investor optimism is directed mainly at foreign stocks, that there is not an overly optimistic view about U.S. stocks.

I suppose that greatest risk is a change in economic fundamentals -- a recession in the U.S, whose extent could be much deeper than in the previous recession, due to all sorts of heightened macro concerns.

Or, since long-term forecasts are so difficult to make, so prone to error, what's the point of being pessimistic? Why be like Stephen Roach rather than like, say, Steve Jobs? As you say, you're not a perma-bear. /C"

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Yes, for all the reasons given above, I believe that the worst case scenario for macro interest rate, commodity price and economy factors would not combine to drive equity prices of the Dow 30 components to below an index value of 9200.

Obviously, even in my mind, there is a possibility that a bottom of 9800 is possible, just as one that is lower than 9200 is also possible. The 9200 forecast is a best estimate, and should it actually happen, it would be a case of a significant bear phase (as opposed to bear market) within a longer-term bull market that I believe would not peak before seeing Dow 14000.

That is hardly a perma-bear perspective.

The most extreme of the inflation-focused bear forecasts could possibly play out, but I put the probability to be minimal. It's just that interest rates do not have to rise that significantly to beat back inflation problems, given that inflation is not that bad today. Besides interest rates today are still at very low levels in a historical perspective.

So too are PE multiples fairly reasonable today. They can, and ought to, go lower because there are risks to capital markets that are not adequately priced in, as I see it. But PE's are not going to collapse unless there is a significant global recession, and I do not see how that is possible today, given the demand of peoples in the emerging economic nations to grow their economies, and the prudence shown this time around by the monetary authorities there.

I continue to be concerned about a possible financial system break-down over the out-of-control credit derivatives market and hedge fund marketplace, but international authorities will soon apply new regulations there.

I also see that after there is a gradual revaluation of the China Renminbi over the next 24-36 months, the USD will be priced more fairly on a trade-weighted basis. That will mean that America's manufacturing base will strengthen, as well as the best quality jobs. For certain this will happen at a time that a new round of consumer buying on a replacement basis will be seen in the auto and PC/mobile technology industries.

As this scenario plays out, the U.S. individual trader will start to bring home monies invested in portfolio securities that have been placed abroad. The bottom line is risk management, and the risks of capital loss are less in North America than abroad.

Finally, I do not expect to see a housing boom and bust scenario playing out. As mortgage rates increase, the bloom will come off the housing rose. However, I don't think there will be a deflation because I think that as the global economy starts to expand again, for reasons given above, I believe that incomes will grow, and that means the ability to service mortgage debt will grow.

However, it is a fact that inflation is rising, the USD will be falling as the Yuan is revalued, and the energy complex is at disappointingly high levels. That means that real wealth is being built slowly, and slower in fact than interest rates and inflation are rising. That is the only scenario that compels me to become a gold bull. So for now I am a gold bull and a financial assets bear.

Posted by Posted by Bill Cara on October 18, 2005 09:29:09 AM | Category: Cara Today in the Market

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