Unrepentant bears

The end is nigh (again)

Pessimistic commentators remain anything but convinced by the stockmarket rally

ALBERT EDWARDS first made a bearish call on the American stockmarket at the end of 1996. As an investment-bank strategist (then at Dresdner Kleinwort, now at Société Générale), he was subjected to a fair degree of ridicule over the next decade, particularly during the dotcom boom. But in the long run Mr Edwards turned out to be right, with last year’s financial calamities his apparent vindication. Had investors sold the S&P 500 index on his recommendation, bought Treasury bonds and held them for the past 13 years, they would have received a higher return.

But in recent months stockmarkets have staged a remarkable rally: the MSCI world index has climbed by 64% since March (see chart 1). Some forecasters say cheerily that the world economy is likely to make a sprightly recovery. Mr Edwards, though, remains bearish. He is one of a stubborn bunch of pessimists who believe that share prices are overvalued and the economic recovery is built on sand. These unrepentant bears are used to betting against the consensus and are not put off by the rally. “I am willing to be patient,” says another notable pessimist, David Rosenberg of Gluskin Sheff, a Canadian asset-management firm. Lately the bears have been encouraged by disappointing American data, for example on durable-goods orders and new-home sales.

The best-known sceptic is Nouriel Roubini, an economics professor at New York University’s Stern School of Business, unimaginatively dubbed Dr Doom (the moniker was first assigned in the financial world to Henry Kaufman, a bond strategist at Salomon Brothers in the 1970s and 1980s). Back in 2005 and 2006, Mr Roubini sounded warnings about the property bubble and the dangers of the American current-account deficit. When the credit crunch hit in 2007, he was treated as a prophet and quickly became a fixture on the conference circuit, delivering jeremiads in heavily accented English (he was born in Turkey and grew up in Iran and Italy).

Mr Roubini’s latest pronouncement, made in early September, was to warn of a slow, U-shaped economic recovery, with below-trend growth for two to three years. (Optimists predict a V-shape, with recovery as rapid as the slide into recession.) He fears that surplus economies like China and Japan will not boost consumption enough to make up for the downturn in American consumer spending.

Shock therapy

In general, the bears take the line that the unprecedented actions of governments and central banks (enormous fiscal deficits, near-zero interest rates and “quantitative easing”) may have jolted the global economy temporarily into life, but they have not resolved the underlying causes of the mess. In particular, they worry that consumers and companies remain excessively indebted, and that deleveraging will quickly stamp out any recovery.

Their usual template is Japan. Its example inspired Mr Edwards to come up with the “Ice Age” thesis in the 1990s as he mused on how assets should be priced in a world of low nominal GDP growth. He thought that the dividend yield on American and European equities would eventually exceed the yield on government bonds. This had come to pass in Japan in the late 1990s and again in the early 2000s, but had not occurred in most Western countries since the late 1950s. It implied a huge derating of shares.

“The bulls’ view of the world was that low bond yields and low inflation should cause high price/earnings ratios,” explains Mr Edwards. But in his view the bulls were ignoring the corollary; that low inflation would lead to low earnings growth. When investors cottoned on to the subdued outlook for profits, as they did in Japan, the effect on share prices was dramatic.

Mr Edwards admits that he consistently underestimated the determination of the authorities to prevent a bear market. As they cut interest rates in response to each market wobble, the result was a series of bubbles, first in technology shares and then in housing.

The other bears agree, and see the recent market rally as simply the authorities’ latest attempt to prop up asset prices. George Magnus, an economic adviser at UBS, a big Swiss bank, says: “This recovery is entirely dependent on the unprecedented largesse of governments and central banks. Things may be better than last autumn when there was an imminent threat of a financial collapse but the recovery is built on very short-term foundations.” In particular, businesses emptied their inventories last year; manufacturing has enjoyed a rebound in recent months as companies have stopped slashing stocks, but Mr Magnus argues it is not self-sustaining.

Mr Rosenberg says government incentive schemes have been behind the housing-market rally and the jump in car sales. Activity was similarly boosted in the fourth quarter of 2001 after the Federal Reserve slashed interest rates in response to the terrorist attacks on New York and Washington. But he points to the sharp slowing of American car sales in September after the cash-for-clunkers programme ended and thinks the same may occur in housing when a subsidy to first-time buyers expires at the end of November.

Because the recovery is so dependent on government support, the bears think it will soon peter out. Mr Edwards worries that the economy will start to turn down in the first half of next year. Mr Magnus thinks the global economy might be able to eke out a meagre growth rate but “if you don’t have credit growth operating, it is hard to sustain spending while unemployment is still rising.”

The bears argue that although governments may have stabilised the banking system, they have not been able to restart private-sector lending. In America bank lending has been falling rapidly over the past three months while in the euro zone broad-money growth has slipped to just 2.5% year-on-year (see the left panel of chart 2). In recent months consumers in Britain and America, two of the most heavily leveraged economies, have been repaying debt (see the right panel).

The problem, according to Mr Magnus, is that household balance-sheet problems tend to last. “They are often linked to property and property busts which take years to play out,” he says. Mr Edwards thinks the outcome will be a reverse of the 1990s boom, when rising asset prices boosted consumer confidence, spending and the economy. Now that share and house prices have dropped, consumers will increase their savings and reduce consumption, weighing the economy down.

The debt problem will act as a permanent drag on the hopes for recovery. Japan had lots of economic rebounds and stockmarket rallies in the course of the 1990s. Over the entire decade, however, the economy was sluggish and investors lost a large proportion of their money. The Nikkei 225 average, Tokyo’s best-known stockmarket measure, is still only a quarter of its peak, reached at the end of 1989.

The bears think many Western economies will face a similar period in the doldrums. “My forecast is not a V-shaped recovery or a W [a second dip, then recovery] but a long series of Us with periods of expansion followed by contraction,” says Mr Magnus. “There is a lot of volatility but the economy doesn’t really go anywhere.”

Just as monetary easing has not resulted in any surge in lending, the bears also think the fiscal element will run out of steam. “The fiscal stimulus has to end, because we can’t keep expanding the deficit,” says Mr Edwards. Either voters will be unwilling to sanction higher deficits, or the markets will take fright and push up bond yields, killing the recovery by a different method. British political debate is already dominated by the need to cut spending and raise taxes.

A rally too far

Given this outlook, the bears believe stockmarkets have got far ahead of themselves: the S&P 500, having sunk below 680 in early March, stood at 1,057 at the end of September. “If the S&P 500 was at 840-860, I would say this is a natural market reaction to the end of a recession, but let’s get a grip,” says Mr Rosenberg. “The market is up 60% from the lows, not 20%. Normally, it takes three years of recovery before the market is up 60%. The rally has occurred while the American economy has shed 2.5m jobs. This market is pricing in 4% economic growth, but what if there’s only 1-2% growth next year?” he asks.

In addition, Mr Rosenberg says investors should be suspicious that the recovery is so dependent on low interest rates and government action. “What is the appropriate multiple that investors should place on earnings that are being propped up by the government? All asset prices are going up together, from gold to Treasury bonds. People say the rally is driven by liquidity. But when every analyst is talking about liquidity you know the top is near,” he argues.

Conventional analysts tend to argue that on the basis of profit forecasts for 2010, stockmarkets are reasonably valued. But bears doubt that profits will rebound so dramatically. They tend to prefer longer-term measures. Andrew Smithers of Smithers & Co, a consultancy, produced a timely book in 2000 arguing that Wall Street was in bubble territory. On his two favourite measures, the q ratio (which compares share prices with the replacement cost of net assets) and the cyclically adjusted price/earnings ratio (which averages profits over ten years), the American market is still overvalued, by 41% and 37% respectively. As chart 3 shows, Wall Street got back to an average valuation by the March lows, but never looked particularly cheap by historical standards.

The bears quoted above are all academics or strategists who can afford to take a detached view when the markets move against them. Mr Magnus is a veteran observer who has seen a few market cycles. Mr Rosenberg has escaped from the optimistic consensus at Wall Street (he worked until last year at Merrill Lynch, which used a bull as a corporate symbol). Mr Edwards has the security of regularly finishing top of polls of London’s favourite strategists, despite (or perhaps because of) his bearish views. Mr Smithers runs his own firm.

Things are rather different for Bill Fleckenstein, who runs a hedge fund at his firm, Fleckenstein Capital. A noted sceptic on the dotcom and housing booms, he closed his short-only fund (which bet on falling prices) in 2008. “I always knew the response to the recession would be printing money and didn’t want to be short any more,” he says. “If they print enough money, stocks can go anywhere they want to.” Crispin Odey, a London hedge-fund manager, has expressed similar views. But this is tactical, rather than strategic, bullishness. Mr Fleckenstein thinks the authorities’ tactics are eventually doomed to failure. “You cannot print your way to prosperity,” he says. In that sentence, he sums up the bearish case.