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Minyan Mailbag: Timing the Next Bear Market




I recently had fun (yes I am an admitted financial dork) sitting with a colleague to communicate what my firm is forecasting over the next few years and how we were investing to combat that environment. We proceeded to enter a debate as to the timing of the next bear market. For all of the market bulls, I have seen a single commonality in their arguments - Relativism. In contrast, there are empirical measures of long term fundamental asset price values, but none of those support the bullish argument and therefore are ignored or mangled to fit the bullish outlook.

For example:

  • 1. The statement that the market has gone nowhere since 1998, yet earnings have doubled, therefore the market must be cheap.

This argument does not address the issue of absolute value - shocking as it may be to many current market participants, stocks actually do reflect fractional ownership in operating businesses and not just pieces of paper! What if stocks were insanely expensive in 1998 and are now simply expensive?

  • 2. The bubble in the late nineties was mostly in technology and large cap growth, and those areas went through a tremendous bear market, so the bubble has been dealt with.

Once again, value of the overall stock market is not addressed and bears fall into this rhetorical trap as well. GMO produces an excellent monthly look at 7 year forecasted returns by asset classes based on the concept of reversion to the mean in valuations. The chart in 2000 looked quite good with the exception of large caps - with many areas showing tremendous opportunity: REIT's, Small Caps, International Large and Small, Emerging Markets, TIPS, Timber, etc... Currently, only timber still is forecasted to produce a decent risk/reward real return - all other asset classes are valued at levels that leave very little probability of much in the way of real returns. As Jeremy Grantham has stated - this is an asset allocator's nightmare. Warren Buffet was buying brick and carpet companies in 1999-2000. Today he is accumulating tremendous amounts of cash.

  • 3. Mr. Dwyer's analogy of the current period to the period of 1992-1997 may be accurate on several levels - all relative.

However, it once again ignores valuation. And by valuation I mean long term measures like normalized profit margins and earnings. Dr. John Hussman has done some very valuable work analyzing peak to peak earnings and multiples on those earnings. For investors to argue that the market is as cheap now as it was in 1992, they are likely playing bait and switch. For example, stating that the market is "cheap" based upon trading at a 16x P/E and that the long term average is 15x's. Of course, the 16x's multiple is based upon forward expected OPERATING EARNINGS at peak profit margins, while the long term average of 15x's is based on trailing NET REPORTED EARNINGS. Dr. Hussman has written that the average multiple on operating earnings when at peak cyclical earnings has been 12x's - and that has been in both low and high inflation and interest rate environments. That is empirical and cannot be disputed. For 2006, a 12x's multiple on expected operating earnings would place the S&P 500 at around 900-950, and that assumes that forecasted earnings will be accurate! Of course, investors may in aggregate decide to pay more than that multiple for a time, but it will not be because there is true economic value present.

There are many others that like the fact that China and the rest of the emerging markets will/are changing the economics of the globe etc., and none of them address the core question of valuation either.

Of course, valuation is mostly a linear measure and investors can and do ignore long term economic value for long periods of time. The portfolio of bullish arguments that are in your column are perfect examples of relative justifications for remaining bullish. Those like Buffet who are more conservative can and do simply sit in low risk vehicles until prices revert to a more normalized level that reflects true economic value. I believe Mr. Reamer and others' work in complexity theory is fascinating because it is a way to attempt to profit from the psychology of the masses - which creates opportunity even during periods when prices deviate greatly from economic value. However, those who are attempting to use linear justifications for purchasing assets at prices that inherently do not provide the opportunity for future long term economic profits and ignore true long term economic value, are playing a very dangerous game in my opinion.

Minyan James


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