Bond investors and value investors tend to be cautious in investing. It is possible to be too cautious, though, and so sometimes it pays to lay out the bull case. Indirectly, I learned this after several years of sitting next to the high yield manager at Dwight Asset Management (a very good firm that few know about). He wasn’t unconcerned about negative developments, but knew that fewer bad things happen than get talked about, and that they tend to take longer to happen than most imagine. He knew that he had to take some risks, because if you wait for the market to correct before you enter, you will miss profits while waiting, and the correction could be a long time in coming.
Also, I fondly remember our weekly economic conference calls in 2002, where the high yield manager and I would take the bull side in the discussions. For me it was fun, because it was so unlike me (I tend to be a bear), and it helped me to learn to balance the risks, and not be a perma-bull or a perma-bear.
So with that, here’s my quick list on what is going right in this environment:
- Earnings yields are higher than bond yields, particularly among many investment grade companies, fostering buybacks and occasional LBOs. Profit margins may mean-revert eventually, but it might be a while for that to happen, given the global pressures that are keeping wage rates low.
- The financing of the US current account deficit is still primarily being done through the purchase of US dollar denominated debt securities, keeping interest rates low in the US. This may shift if enough countries experience inflation from the buildup of US dollar reserves that they do not need, and allow their currencies to appreciate versus the US dollar. That hasn’t happened in size yet.
- ECRI’s weekly leading index continues to make new highs.
- Money supplies are growing rapidly around the world. Most of the paper is creating asset inflation, rather than goods inflation so far.
- Bond yields have moderated since the yield peak in mid-June. Spreads on corporate investment grade debt have not widened much. Financing is cheap for the creditworthy.
- Short sales are at a record at the NYSE. Part of that is just the influence of hedge funds.
- Vulture investors have a lot of capital to deploy. Marginal assets are finding homes at prices that don’t involve too much of a haircut. (I’m not talking about subprime here.)
- On a P/E basis, stocks are 45% cheaper than when the market peaked in March 2000.
- Sell-side analysts are more bearish than they ever have been.
- Investment grade companies still have a lot of cash sitting around. The washout from 2000-2002 made a lot of companies skittish, and led them to hold extra cash. Much of the cash has been deployed, but there is still more to go.
- The FOMC is unlikely to tighten before it loosens.
- Yield-seeking on the part of older investors is helping to keep interest rates low, and the prices of yield-sensitive stocks high.
- DB Pension plans and endowments are still willing to make allocations to private equity.
- The emerging markets countries are in aggregate in better fiscal shape than they ever have been.
- Trade is now a global phenomenon, and not simply US/Europe/Japan-centric.
- The current difficulties in subprime are likely to be localized in their effects, and a variety of hedge funds and fund-of-funds should get hit, but not do major damage to the financial system.
Now, behind each of these positives is a negative. (Every silver cloud has a dark lining?) What happens when these conditions shift? Profit margins fall, interest rates rise, inflation roars, risk appetites decrease, etc?
These are real risks, and I do not mean to minimize them. There are more risks as well that I haven’t mentioned. I continue to act as a nervous bull in this environment, making money where I can, and realizing that over a full cycle, my risk control disciplines will protect me in relative, but not absolute terms. So I play on, not knowing when a real disaster will strike.
Editing note — my apologies. The second paragraph omitted the word “not” in the original publication. What a word to omit, not.