Why the Bearish Argument on Stocks Isn't Just Bull

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Why the Bearish Argument Isn’t Just Bull

Yes, unfortunately, this article is going to be a continuation on the theme of “what does last week’s sell-off mean.” Also, Friday’s decline means that I owe readers another stock pick per my article on housing and credit plays. First though, some general economic commentary. There are many people out there who say that right now the market is going through natural corrective motions, and you shouldn’t be worried about the fundamentals because everything is just fine. If you were a doctor looking at an obese patient with a weak heart and high blood pressure, would you say everything is fine if there were no immediate problems? If you would, I know a medical malpractice attorney who needs to fund his presidential campaign and/or hair styling appointments… but I digress.

Speaking as both a country as a whole and on individual levels, America carries too much debt. The amount grows every day too, and that trend shows no signs of stopping. Our government is burning through an additional $1 billion each day in debt on top of the $9 trillion and change we already owe. Thankfully, there are enough people looking for “risk-free” returns that interest rates remain reasonably low, but how long can this subsist? Take that rhetorically, it doesn’t matter if it is two years, one decade, or until my hypothetical future kids grow up, it simply is not wise to operate our government with such a huge deficit. The more disturbing issue with government debt is that it seems like we have no exit plan in sight for even starting to go on a proverbial diet, and instead will keep packing on the pounds until it kills our country. I don’t like to get preachy-political, but this is why I don’t care about gay marriage stances, gun control, or immigration: answering any of those questions has no material impact on the well-being of America. Figuring out how to save our nation from insolvency does.
I’d like to think that the rampant fiscal mismanagement we see in government is limited there, but individuals have plenty of culpability here too. Financial institutions are great at working out ways for people to load themselves up with more unhealthy debt, and the obvious point here involves sub-prime mortgages. According to an article published today in the Philadelphia Inquirer, 13% of loans in the Philadelphia area qualified as “sub-prime” in 2005, and these will be resetting over the next 18 months to the tune of 30% average payment increases. Maybe, for once, many people are going to realize the damaging effects of too much debt. After looking at the data (which you can view at the link above), even I was surprised by the extent of the problem. Some areas have incidences of sub-prime loans running close to 60% of originations, and I can’t see a way this works out positively. The one tad of irony in the story is the biggest sub-prime lenders were New Century, H&R Block’s (HRB) Option One, and Fremont Mortgage. New Century is bankrupt, and the two others are in the process of being sold for below book value. Point #1 on the bear side: the American debt burden is real and heavy. Money that goes to servicing debt - be it home mortgage, government bonds, or private equity financing - is not going into grow the economy. I could go much more in debt with this point, but for the time I hope this is sufficient.

Another troublesome point is the connection between currency, inflation, interest rates, and trade. Everyone knows America runs a huge current account deficit with the rest of the world as our imports far exceed our exports. I am not one to argue a zero-sum trading game, but the size (about $200 billion per quarter) and persistence make this deficit worth consideration as a potential problem. Warren Buffett, after all, has compared it to a family selling off a portion of its farm each time it needs to pay for things. Rather than worry about when the current account deficit will correct or reverse, it is more important to realize how crucial foreign imports are to our functioning, and the catastrophic consequences of the end of cheap imports. In macroeconomic terms, there are considered to be a few given cause-and-effects, like lower interest rates boosting GDP growth whereas higher interest rates clamp down on inflation. The other side of this is the currency game, where higher interest rates result in a stronger currency and interest rate cuts weaken the unit. A weaker currency unit effectively makes foreign goods more expensive, and a stronger currency effectively makes them cheaper. Now compare the effects of interest rates on inflation with the effects on currency, and you see they are almost opposites. Pull up a chart of the Fed Funds rate and compare it to the US Dollar Index (expand to the 3-year view on StockCharts.com) and note that around the time interest rate hikes went on hold, the value of the dollar plunged. It took raising rates pretty much continuously to keep the USD above 87 or so. Follow me here… if we want a stronger dollar (and hence less expensive foreign goods to minimize price inflation) we need to raise rates… slowing the domestic economy at the same time. If we want to open the gates and let the economy run, we can cut rates - while also sending our currency into a free-fall and driving up the prices of all our imports. How to we end up with some sort of significant real GDP growth under either of those conditions? Forget changing interest rates on way or another right now, how do we have any real economic growth under current conditions? We’ve seen extremely weak growth excluding the most recent GDP report (which I believe is an anomaly), and while the Fed can be “cautiously optimistic” that core inflation is only 2.5%, real inflation is north of 5% and likely even higher. As noted in Barry Ritholtz’s The Big Picture blog, we’ve already seen a retail rally that was a “celebration of higher food prices.”
Point #2: The Fed has little room to lower rates given the delicate balance of trade, inflation, and growth. At the same time, raising rates would be intelligent but exceptionally painful for the already-debt-burdened consumer.

Of course, the ever-present rallying cry of the bulls for this rally has been “double-digit earnings growth.” Nice earnings growth, after all, leads to forgiveness of many sins. The question with earnings growth is two-fold: first of all, was it really high-quality organic growth, or just the result of cheap debt that allowed businesses to expand at low costs through leverage and consumers to run a tab? This is, of course, open to interpretation, but to extrapolate the positive results of the recent past and pretend that automatically bodes well for the future is completely irresponsible. Let’s be clear: profit margins are near an all-time high and are questionable in their sustainability, increasing commodity costs are going to have to factor into the system, and consumers have been extending themselves to an exceptional degree that cannot persist indefinitely.
Point #3: Valuations are high relative to their normal cycle and offer only a small premium over bonds. All this comes on the heels of extremely advantageous business conditions that certainly helped bolster many companies’ profits. Should their valuation multiple thus be set using those recent (likely inflated) numbers? This calls to mind the Graham quotes that “the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.”

Say what you want about the correctness of the bearish argument, but don’t pretend there aren’t some real points behind it.