The Bears
Look Back.
The Bulls Look Forward
By George Dagnino, PhD
Chairman, Peter Dag Strategic Money Management
Editor, The Peter Dag Portfolio Strategy and Management,
The
bears look back. The bulls look forward. Investors' psychology
is fascinating. They react to what is happening. If the environment,
as depicted by the press, is dismal, they panic. Emotions take
over. Decisions are made to avoid stress, not to take advantage
of opportunities.
Major market bottoms
have always taken place in the worst of times. Economic failures
of entire regions of the globe (as in 1997 in Asia, Latin America,
and Russia), bank failures in the US (as in the 1970s and in
the early 1990s), recessions and sluggish economic conditions,
and special events such as concerns about the Y2K, have all been
exceptional buy opportunities.
The majority of investors
have a sense that bad times are associated with bear markets.
What they fail to recognize is that markets move ahead of economic
and financial conditions. The stock market (S&P 500) peaked
in 1999 when liquidity began to grow more slowly. The economy
slowed down in 2000-2001 because of decreasing liquidity. The
market anticipated current conditions.
My point is that to
be bearish because the economy is weak is like driving while
looking in a rear view mirror. On the other hand, bullish investors
know that the stock market and liquidity rise ahead of improving
economic conditions. Their eyes are fixed on the developments
that will create a favorable economic environment. Liquidity
and stocks anticipate the "good times".
You can rest assured
that the next bull market will be almost over by the time the
bears realize the economy is booming. They believe, mistakenly,
that good times are associated with bull markets and will buy
aggressively at the top.
Investment opportunities
arise when there is a smell of panic and people are confused.
You need to convince yourself that right now everything is being
done in Washington to stimulate the economy. Taxes are cut. Spending
is rising. Interest rates are reduced aggressively. Liquidity
is soaring. The majority of investors are still afraid of what
is happening (because they look back).
Everything that is
happening, every little piece of information, points to a desperate
effort to make the economy boom again. There is no doubt in my
mind that this is the time to be aggressive and be fully invested.
You have to look forward.
Financial Markets
The Stock Market: The
S&P 500 is in a solid up-trend. It is up more than 14% since
the lows of last September. We are witnessing a major move in
stocks. The string of positive news is increasing.
We are now in the midst
of the favorable seasonal period, and the market is obliging
those faithful market watchers who believe in this very reliable
statistic.
The
level and trend of bond yields justify higher prices when compared
to earning yields (computed as the inverse of the PE ratio).
The growth of monetary
aggregates is strong and is likely to continue to expand at a
solid pace.
Short-term interest
rates and commodities continue to sag.
The advance-decline
line remains in an up-trend.
The dollar is firm.
The global central
bankers are busy printing money to avoid a serious and prolonged
global recession.
Sentiment among the
investment letter writers is still cautious.
The put-call ratio is bullish.
Can the market go much
higher given current valuation levels?
This is a tough question to answer. The bottom line is that there
are many solid stocks with low PE and providing some interesting
yields. I believe they will continue to remain attractive. As
far as the broad averages are concerned, the current PE of the
S&P 500 is 30. There is no doubt the upside potential is
limited to 15-20% from current levels.
Foreign Interest Rates and Equity Markets
Foreign
short-term and long-term interest rates are sagging. The global
economy is slowing down in a perfectly synchronized way. Meanwhile,
the IMF is busy lowering its growth forecast for the world in
2002. They always lag what is happening.
The global central
bankers keep adding liquidity to the system. Meanwhile, Washington
and other power centers are planning all types of stimulus packages
to support the economy and improve consumer confidence. The outcome
will be a robust global economy in 2002-2003, preceded by strong
foreign equity markets.
What needs to be watched
carefully at this stage of the business cycle is the dollar.
Weakness in the dollar will signal higher inflation, higher bond
yields, higher commodities and a weak stock market. Right now
the dollar is firm, but certainly not ebullient.
Short-Term Interest Rates and the Fed
The
weak economy is forcing interest rates to decline. The Fed is
easing accordingly by lowering the interbank rate (fed funds
rate). In the process it keeps printing money.
The rate on 13-week
Treasury bills is now below 2%, lower than the inflation rate
by more than half a percentage point. In other words, the cost
of money is "negative" by a margin not experienced
for a long time.
This is going to hurt
us. By the end of 2002 and into 2003, because of the current
cheap money policy, inflation will begin to raise its ugly head.
However, in the near term there is no doubt monetary policy is
very bullish for stocks.
Bond Yields and the Yield Curve
Yields
continue to decline. Yields on 10-year bonds have declined sharply
to 4.36%. The outcome is that real bond yields are unusually
low, at levels seen only at a major bottom in yields. For this
reason I believe yields are very close to the bottom. Besides,
we are at the end of the favorable seasonal period for bonds,
which is another sign of caution. Meanwhile, the yield curve
remains very steep, reflecting financial conditions conducive
to a strong economy.
Bonds have become unattractive
at these levels. On the other hand, with inflation looming on
the horizon, inflation protected Treasury bonds have become quite
attractive for conservative portfolios.
One way to profit from
rising yields is to short bonds. Rydex has a mutual fund that
shorts bonds (Juno) and offers investors an opportunity to capitalize
on rising inflation. I am not saying this should be done right
now, but it is my plan to capitalize on my outlook. Stay tuned.
Commodities
Commodities
are very weak. The exceptions are natural gas and gold. I am
still bearish on the commodity complex. For this reason it is
premature to even think about going long commodities. By the
way, an alternative to going long commodities is to go short
bonds.
Gold and energy stocks
are still acting well on a relative strength basis.
The Business and Financial Cycle
Do
you remember when Mr. G and all his loyal followers were talking
about a new economy revolutionized by information technology?
What IT was supposed to create was a new leap in productivity
to levels never seen in this country.
The latest data released
about the economy and productivity throw some cold water on the
enthusiasm of the Chairman of the Fed. The average annualized
growth rate of GDP has been 3.1% since the cyclical peak of July
1990. In the economic cycle between 1973 and 1980 we experienced
an average growth rate of 2.9%. Productivity of the non-farm
sector grew only 1.46%, down from the 4% growth rates of just
a few years ago. It looks more and more like the 1990s were not
the exceptional times we were led to believe.
My point is that the
economy looked strong in the second half of the 1990s because
of the huge injection of liquidity orchestrated by the Fed to
protect the banking system from the various crises that took
place from 1997 to 2000. This liquidity was the main cause of
the investment bubble of the 1990s. What we experienced was not
an economic miracle. We will be paying for the liquidity splurge
that has been taking place since 1997 for many years to come.
Meanwhile, my leading
indicators keep heading up and are very strong. They continue
to point to a strong economy in 2002.
The coincident indicators,
which reflect current economic conditions, are still very weak.
Employment, consumer confidence, unemployment claims, the index
of the National Association of Purchasing Managers, and orders
for durable goods reflect very weak business activity. The only
signs of life came from car sales and the percent of purchasing
managers reporting slower deliveries. They displayed some strength.
This is good news, but too little to jump to any conclusion.
The weakness of the economy continues to point to even lower
lagging indicators.
The lagging indicators
are heading down, as they always do in times of economic weakness.
Commodities, short-term interest rates, bond yields, and backlogs
are in a downtrend. The only exceptions are natural gas and gold,
which are firm. The protracted weakness of the lagging indicators
continues to point to strong leading indicators for the next
several months.
The powerful relationship
between these indicators and how it can be used in your investment
program is discussed in detail in my book Profiting in Bull
or Bear Markets.
Editor's Note: Dr.
George Dagnino is author of the book Profiting in Bull
or Bear Markets published by McGraw-Hill.
He is also editor of The Peter Dag Portfolio Strategy
and Management, 1 year, 24 issues, $225, since 1977.
Mr. Dagnino is an economist,
strategist, portfolio manager, and author. He is an active lecturer
on the impact of business and financial cycles on investment
and business strategies. Visit www.peterdag.com for more information
on Dr. Dagnino's services.
