A Bullish Case

Investors are too often swayed by ominous forebodings. Inflation, housing and debt–oh, my! The simple truth is that stocks on the whole rise more often than they fall. You should be in the market unless you have a damn good reason to be out. What follows is a compelling bullish case, borrowed from the web site of economist Ed Yardeni:

Financial crises stay self-contained and don’t become contagions. Six recent crises that weren’t. Despite inverted yield curve, banks having no problems attracting deposits. So bank credit remains plentiful.

I) ECONOMICS: Last year, the Alarmists warned that tighter monetary policy in the US and overseas, along with the inverting yield curve in the US would trigger a financial crisis. They predicted that it would cause a financial contagion, which would lead to a global recession and a huge bear market for stocks. A few less alarming economists agreed that a financial crisis was increasingly likely, but the consequence might be more bullish for stocks. In their scenario, the Fed would respond quickly to the financial crisis by lowering interest rates. Instead of a recession, there would be a mid-cycle slowdown. This would depress earnings growth, but lower interest rates would boost valuation multiples. The fact is that we have already had a few financial crises, but no contagion. Indeed, the crises have been so well contained that some observers might question whether they should even count as such:
(1) Last year, there was the downgrading of the credit ratings for the bonds of GM and Ford. The domestic auto industry has been undergoing a wrenching restructuring including lots of job losses. During the 1970s and 1980s, such a major trauma for this major industry most likely would have caused a recession. GM’s stock price was actually up 58% last year, making it the best performer in the DJIA.
(2) Amaranth blew up last September. The hedge fund lost $6.4 billion in a few days last year in the worst debacle in the industry’s history. Long-Term Capital Management lost $4.6 billion in less than four months in 1998 and roiled the markets. The Fed was forced to organize a rescue operation for LTCM and to lower interest rates. There were no shock waves when Amaranth was forced to shut down. Indeed, Nick Maounis, Amaranth’s chief executive, is already considering launching a firm with some former colleagues from the fund.
(3) The meltdown in emerging stock markets last May felt like a global financial contagion. It was triggered by news that the Bank of Japan was about to abandon its zero-interest-rate policy. The BoJ did raise its official rate to 0.25% on July 14, 2006. However, all the fears that this would unwind carry trades evaporated quickly. By last summer, most emerging stock markets had recovered with many at new record highs again.
(4) Will the recent nationalization moves in Venezuela and Bolivia, as well as the threat of a debt default in Ecuador, spill into other markets? A similar series of events occurred in 1999, when Ecuador defaulted on Brady Bonds around the same time Columbia and Chile abandoned a currency peg, letting their currencies float against the dollar. Argentina defaulted on its debt two years later, costing investors and governments about $140 billion. And not long after, there was concern that Brazil would end up imposing capital controls and defaulting as well. The good news is that the region is more stable today. Morgan Stanley noted at the end of the year that “Brazil has zero net public external debt (net of international reserves), a declining debt path for its domestic debt, and inflation hovering around that of the U.S.” The country is running a current-account surplus (WSJ 1/11/07).
(5) Thai stock prices have lost 10.4% since Dec. 19–the first trading day after Thailand unveiled its new capital controls, which required foreign investors to deposit 30% of the money they bring into the country with the central bank. This was aimed at stalling the rapid strengthening of the baht, which was beginning to depress exports. The stock market immediately plunged in its biggest one-day loss ever. The selling continued through December and into January, when the military-installed Thai government announced its second big policy shock: new rules limiting foreign shareholding in businesses operating in Thailand. The result was another round of selling until the government belatedly clarified that only a few businesses would actually be affected by the proposed rule changes. A series of bombs that exploded on New Year’s Eve in Bangkok put investors further on edge. Still according to the WSJ (1/18/07) some investors are buying again because Thai stocks are so cheap. The P/E for Thailand’s overall market is 5.9 times. That compares with 14.7 times for Singapore, 17.8 for Malaysia and 18.1 for Indonesia.
(6) What about the US subprime mortgage market? Is that the next financial accident that will unleash a contagion? I doubt it. However, a study from the Center for Responsible Lending projects that one out of five subprime mortgages originated during the past two years will end in foreclosure. (See link below.) The CRL is “a nonprofit, nonpartisan research and policy organization dedicated to protecting homeownership and family wealth by working to eliminate abusive financial practices.” I am still studying their study, but my initial take is that it is a bit alarmist, though clearly there are and will be households that will lose their homes. I don’t believe there will be enough to cause a recession. Since most of their mortgages have been securitized, I don’t expect that rising foreclosures will cause a financial meltdown either.