A Stealthy Bull and the Bubble in Fear
By Farnum Brown
In our January market commentary we said the bear market in stocks was over, having ended on October 9 of last year. In our April commentary we said that as geopolitical risks declined and the economy and corporate earnings recovered, the market’s reasonable valuation left plenty of “headroom” for rising stock prices. With the S&P 500 up 15.40% last quarter the market indeed found “headroom,” far more than we would have dared predict, turning in its best quarterly performance since the fall of 1998.
As investors wake up to the fact that a “stealth” bull market in stocks has taken the S&P 500 up 28% from its October ’02 lows, the question we hear most is: Is this for real? Or, alternately: Isn’t the recovery in stocks already over? Which translates to “Haven’t I already missed it?”
We’re delighted that these are the questions on virtually every investor’s lips. They signal doubt, skepticism, disbelief and, best of all, fear. These are not the prevailing sentiments found at bull market tops. They are rather the sort found in the early stages of a new bull market that arises from the ashes of a severe, sustained bear market such as we’ve just experienced. Quite a lot of pain was meted out to many investors over those three years, so investors’ caution levels–as measured by what they’re actually doing with their money–have naturally risen to extremely high levels. The best indication of this we’ve seen yet is shown below, courtesy of BCA Research.
The top graph shows the dollar value of cash deposits in the US (short-term deposits like money markets, checking accounts, etc.) relative to the value of the Wilshire 5000 stock index, which is virtually all US stocks. As you can see, cash–a.k.a. buying power–is at record levels relative to the stock market, having exceeded even the highs reached in the early 1980s when the last great bull market began. The bottom graph shows the paltry interest being earned on that “Mountain of Cash.”
The Supply/Demand Picture in Financial Assets
The bubble in greed that inflated the stock market in 1999 has been deflated and replaced by a bubble in fear that drove the price of bonds, particularly US Treasury issues, and the size of investors’ cash hoard to dramatically inflated levels. This, of course, means that interest rates on bonds and cash have been driven to extremely depressed levels, indeed, the lowest in almost half a century. The same herd that piled in at the top of the stock market has now piled in to the top of the bond market.
As investors wake up to the solid returns from stocks while seeing their bonds and cash earn near zero after inflation, some of that Mountain of Cash (and bonds/bond funds) will get jealous. Some of that Mountain will start to migrate over to stocks, pushing up stock prices with buying and pushing down bond prices with selling. Indeed, it’s already begun. Through this reciprocating action of better stock returns and worsening bond returns the pendulum, which has swung from one historic extreme to another over the past five years, will move back toward the middle. The current relationship among stock prices, earnings and interest rates tells us that stocks remain significantly undervalued while bonds remain significantly overvalued.
The Economic Picture
Aiding and abetting this process is the Federal Reserve, which continues to push short-term rates to extremely low levels, thereby holding down all other lending rates from longer maturity bonds to home mortgages to commercial loans, etc. This is being done to insure that the economy revives (in time for the elections next year). We expect these efforts to succeed. In addition to the lowest interest rates in decades the federal government is refunding and cutting taxes while rapidly increasing deficit spending. And the US dollar is gently declining, which makes US goods more competitive in the world. All of these are powerful economic stimuli, which work with a lag. We think the cumulative effects of these stimuli will register in the second half of this year with more to come in 2004.
There are two main risks to this outlook: a Japan-style deflation in the US and other, “exogenous” events like terror attacks or the outbreak of war. Given that we’ve suffered so many such events over the past couple of years, many of those can no longer be considered truly exogenous: the costs of war and terrorism are now part of every business model, whether explicitly or implicitly. We say this not to dismiss these factors but only to point out that they can’t have the same impact on the economy or the market because they can no longer surprise us.
As for Japan-style deflation, we question how deflation arises with oil prices at $31 a barrel, up from $11 a barrel a couple years ago, the CRB Index of industrial commodities up 31% in the past 18 months, the Federal budget growing a deficit and a declining dollar that creates a mildly inflationary effect in imported goods. We don’t buy it. So, we think this stock market recovery is real and has a ways to go, though we expect it will be bumpy along the way. One caveat to our generally favorable outlook: heightened geopolitical risks lead us to keep equity exposure somewhat lower than we would normally, given our economic forecast.