A Mid-Year Bull vs. Bear Investing Debate
Comment of the Day

July 21 2010

Commentary by David Fuller

A Mid-Year Bull vs. Bear Investing Debate

This is a topical Q&A article (may require registration, PDF in Subscriber's Area), with Gregory Zuckerman of the WSJ interviewing David Rosenberg and James Paulsen. Here is the opening
Investors are dazed and more than a bit confused. The first week of July was the best week for stocks this year; the previous week was the second worst of 2010. Bears and bulls are torn about the direction of earnings and the global economy, the health of consumers and how attractive stocks are.

To get a better understanding of where the market is headed and what investors should look out for, we called on two thoughtful investors, David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates, a noted bear, and James Paulsen, chief investment strategist at Wells Capital Management, a leader of the bull camp.

Q: Where is the market headed the rest of this year and over the next 12 to 18 months?

PAULSEN (the Bull): Investor optimism, which got ahead of itself in early spring, has been checked, considerable liquid asset holdings are on the sidelines and concerns about a potential double-dip recession seem overblown. Recently the dividend yield on the Dow Jones Industrial Average rose above the 10-year Treasury-bond yield for the first time in decades, and the price/earnings multiple on year-end estimates has declined to about 13.

With interest rates and oil prices down, earnings still rising and policy officials showing no inclination of taking the punch bowl, the upside potential for stocks is encouraging.

ROSENBERG (the Bear): The market is not cheap. By the end of secular bear markets, stocks trade no higher than P/E multiples of 10 and at least a 5% dividend yield. We very likely have quite a long way to go on the downside.

The market moves in cycles -- 16- to 18-year cycles, in fact. This secular down-phase began in 2000. The best we can say is that we are probably 60% of the way into it. In a secular bear market, rallies are to be rented, not owned. We're in a primary bear market, not unlike what we endured from 1966 to 1982. Back then, the principal cause was inflation; this time, it's deflationary debt deleveraging.

Within the next 12 to 18 months, I can see the Standard & Poor's 500-stock index breaking back below 900 [it's currently at almost 1100]. A substantial test of the March 2009 lows cannot be ruled out.

David Fuller's view Ever since the telecom and technology bubble burst in 2000 Fullermoney has discussed a cycle of valuation contraction on Wall Street, similar to what we saw from 1966 - 1982, albeit for different reasons, so I agree with David Rosenberg on this point. Moreover, the USA's economic problems are considerably worse today than back then.

Does this support David Rosenberg's bearish market forecast, or will the points raised byJames Paulsen be more influential? And what other factors may determine the outcome?

The valuation contraction discussed by David Rosenberg and Fullermoney is a very good reason, in my view, to avoid an S&P 500 Index tracker or any other broadly diversified long-term US stock market portfolio over the next several years. However for Rosenberg's forecast of S&P 900 or possibly even a test of the March 2009 low to occur, would require I suspect, either a massive exogenous shock such as another spike in the crude oil price, or exceptionally poor governance from the White House and Federal Reserve.

Extreme commodity price inflation such as we last saw in 1H 2008 is possible, even probable when the global economy is next synchronised in a sustained period of GDP expansion. However this is less likely while most OECD economies continue to experience below trend GDP growth.

On governance, some will always argue that it is THE problem because perceptions vary. However, it is a concern when a significant proportion of the business community concludes that the White House is both inexperienced and anti-business, as we hear today. While one should not ignore or deny these perceptions, to a certain extent the White House is reacting to a pre-election view by many Americans that Bush Administration cronyism with business leaders was the problem.

Looking ahead, the US economy will certainly have fewer successes if the Obama Administration is unable to develop a good relationship with the business community. I maintain that the government needs to create an internationally competitive business environment, to generate more inward investment by US firms and also to attract international companies which could invest in America.

Returning to the Paulsen / Rosenberg debate above, my view is more in line with the former but monetary policy and corporate profits are the key factors. If the economy continues to grow, even at a modest rate, valuations can contract without another significant stock market plunge, which I maintain is now less likely in the next few years following 2000-2001 and 2008-1Q 2009 meltdowns. The interest rate environment remains benign, as is the yield curve. Wall Street was not hitting new lows in the build-up to 2Q 1982's bargain S&P 500 yield of 6.21%.

Yes, western economic conditions are worse today than in the late 1970s and early 1980s, but this problem is somewhat mitigated by vastly stronger Asian-led so-called emerging market growth today. (See also yesterday's comments on the S&P.)

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