Constructive Zone

Gotta see the show 'cause then you'll know
The vertigo is gonna grow
'Cause it's so dangerous
You'll have to sign a waiver
--Barenaked Ladies

Thoughtful piece from Kevin Depew proposing that the time for bearishness is behind us. He proposes that it is now time to be thinking about how to intelligently position for a secular bull market. His basic rationale is that we have been in a bear market for more than a decade, and combined with current sentiment and particular technical indicators, he thinks it's time to get more constructive. He also suspects that there may be a 'Black Swan' event that positively pushes markets higher in a secular manner.

Perhaps Pep is right..he's one sharp cookie. But I have some reservations. Let's look at my concerns using the 'structural, technical, fundamental, psychological' framework.

Structural. The underlying causes of this bear market are structural in nature. We've had a classic 'crack-up boom.' A credit fueled bubble in economic activity stoked by interventionary action followed by debt poppage. This debt bubble began in the early 80s (actually one could persuasively argue that it began much earlier than that) and hit hyperspace during the 1990s-2000s. The 'pop' began in 2007 with probs in subprime mortgages. This was only 3 yrs ago. While 'popping' the bubble seems like a one-off event, debt destruction is actually a process likely to persist many, many years.

If we examine previous cycles, the popping process was going strong for a decade during the Depressionary 1930s when WWII and its consequences intervened. Japan is still at it today after the process began over 20 years ago for them. Because the bubble blown here was the biggest in the history of the world, it seems reasonable that we may have many years to go.

While it is certainly possible (in fact likely) that stocks could rally hard in the face of this (as they did in early 2009), the structural headwinds of deleveraging will likely be blowing in the face of stocks for some time.

Technical. Pep claims that stocks have been in a bear market for at least ten years. This claim depends on a) your definition of a bear market, b) which stocks you're talking about, and c) the time horizon. If stock prices have 'gone nowhere' for a decade, then is that a bear market? I like to think that bears markets are long term periods of signficant price declines. If I call up charts of the 3 major US stock indices, only the COMP has the look of a depressed market that's been dead in the water for many yrs. The SPX can be seen as oscillating in a trading range, but it matched it's all time high in 2007. The Dow looks even more positive, clearly marking an all time high in late 2007. In fact, one could argue that the Dow is only now tracing out a huge 10 yr head and shoulders top--suggestive that the 'real' bear market migh lie ahead.

On broad indices, it's hard for me to buy the argument that we've been in a bear market for a decade. The charts suggest to me that, similar to the structural conditions of debt destruction, real downtrends in stock prices seem more likely to have commenced in late 2007/early 2008.

Fundamentals. In the past 100 years, the worst bear markets have ended when stocks are dirt cheap. The metrics often cited are PEs of 5-9 and dividend yields north of 6%. We're far away from those benchmarks. At current levels, stock prices would need to fall 50% to approach these benchmarks. I should mention that from a discounted cash flow perspective, most stock prices suggest similarly heroic assumptions about future prospects for creating economic value.

Psychology. Pep claims that 'everyone' is bearish. I've been trying to steer clear of such 'point estimates' in favor of thinking about distributions. Because markets are necessarily two sided in perspective (otherwise nothing would trade), it is always possible to find extended examples of sentiment that support one's view. As such, instances of selective reasoning, a basic human defect, are writ large in financial markets.

In the near term, it did seem to me that more folks than usual, especially those in mainstream media, were bearish. Heck, I'm long a small basket of stocks in a humble attempt to catch a relief rally in sentiment. But we've seen these near term situations before. Longer term, my sense is that sentiment will grind lower toward a level where perhaps people are ready to board up exchanges. We're a long way from that.

It is often said that in serious bear markets, no one makes money--not even the bears. I suspect a key reason for this is that over time bears who were correctly positioned early in the decline wade back in the pool too early, and they subsequently get their heads handed to them.

My personal plan is to not get involved in stocks in a serious, long term way until I see the ducks (as expressed by the conditions outlined above) lining up across the board. Currently the quack count is low, not high. I'm hopeful that this happens in my lifetime but it may not (again witness Japan).

I'm a card-carrying contrarian and at times it's tempting to perceive that things have gotten so lopsided that the world is on the other side of the trade. When that happens w.r.t. stocks, I try to remember where we stand versus those valuation metrics that define generational market lows.

Meanwhile, focus remains on return of capital rather than return on capital.

position in select stocks