Bread Vs. Cake Part II

October 22, 2009


Cake And Bread Eaters

A comparative review of Wells Capital Management's strategist James Paulsen’s Six Good Reasons to Like Stocks, featured in the August 2, 2009 Barron’s magazine, and Ned Davis of Ned Davis Research’s (NDR) take on secular vs. cyclical bull markets posted at on July 30, 2009, shed light on secular vs. cyclical views.

Mr. Paulsen likes cake. He is a secular bull. Mr. Davis prefers bread. He is a cyclical bull and a secular bear.

Ned Davis’ Seven

To figure out whether we are in a bear or a bull, Ned Davis identified seven factors to determine if any given market low is a secular low, setting up the next multiyear bull market.

His seven factors are followed by his take on things:

1. Money, cheap and amply available (neutral);

2. Debt structure that’s been deflated (bearish);

3. Large pent-up demand for goods and services (bearish);

4. Stocks that are clearly cheap (now bearish);

5. Investors who are deeply pessimistic (bullish);

6. Major investor groups with below-average stock holdings (neutral);

7. Fully oversold, longer-term market conditions (neutral).

A couple of months back, Mr. Davis found just one of the seven foundations for a new secular bull market. Three were neutral and three bearish.

James Paulsen’s Six

Mr. Paulsen never clarifies if we are in a strong cyclical bull or a new secular bull market. He simply couches his views with “it seems like we are in conditions like we were in the summer of 1982, when one of the strongest and longest bull markets in history began.”

His six factors are as follows:

1. Stocks are still cheap, signaled by their current price/earnings ratio of 15;

2. Corporate profits are spring-loaded to catapult higher even without strong economic growth;

3. The "dominance of doubt." Investors are too pessimistic;

4. Cash holdings amounted to about 95 percent of the value of
U.S. stocks;

5. Productivity, or output per man hour, has risen even during the economic slide;

6. One shouldn't fight the Fed and global government stimulus.

Mr. Paulsen’s views on the market are in line with “V”-shaped or strong and sustainable economic growth. Mr. Davis’ views are in line with “W”- or “L”-shaped economic growth associated with a double-dip recession and sub-par growth.

Mr. Paulsen mistakes a strong cyclical bull market for a new bull, and his view on a strong recovery is not in line with the historic climates seen for years following past global financial-crisis-led recessions. For example, his estimation that current times are like 1982 is wrong.

Things are not like 1982.Then, the unemployment rate had already peaked. More importantly, we have been in a once-in-a-century structural shift in global production, consumption and saving since globalized trade and production accelerated in 1989. Since then, following both the 1990-1991 and the 2001 recessions, unemployment has remained high and lagged the recovery. For all prior recessions in our history, unemployment was a coincident indicator.

Also unlike nonfinancial-crisis-led recessions, our current downturn began with plunging home values and a credit crisis that led to a rapid contraction in credit. Normally, the recession-recovery sequence begins with higher interest rates, declines in stock values and junk bonds, higher unemployment, declines in consumer confidence/spending, declines in business spending, a rise in personal savings, declining or stagnant home values, declines in commercial real estate values and tight credit conditions.

Unlike past recessions, this one began with a decline in home values in June 2006. Although the Fed did raise rates to initiate this downturn, higher rates simply kicked off a cycle of asset deflations and a credit panic/freeze. Despite positive economic signs since March 2009, the rate of job loss remains high and the unemployment rate has continued its rise, credit remains tight, savings is too low and business spending is anemic. History is full of instances where recessions have relapsed after two or three quarters of growth.

A Great Short

Figure 1 helps us to prepare for a big shorting opportunity coming soon from companies and funds recently driven to nosebleed levels of valuation. Most of these securities are dependent upon health in the commercial real estate sector. Commercial real estate exposure in
institutions is $3.54 trillion. Losses are expected to range between $142 billion and $248 billion based upon 4 percent and 7 percent loss rates. Our best guess is the latter. An area of opportunity exists for shorting securities that will be out some of the $129 billion in private funding shortfalls estimated on loans that need to be rolled in 2009-2010.



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