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Making the Bull’s Case and the Bear’s Case

March 14, 2005

This week's analysis comes to us from Steve Leuthold of The Leuthold Group. They are located in Minneapolis and put out lots of financial analysis including the monthly Perception for the Professional.

In the publication is Steve's monthly commentary called "View from the North Country" and this month's topic takes a look at the bull and bear arguments for the markets. Bullet points of some of the top arguments for a bull and a bear market are presented followed by Steve's viewpoint on the subject. Many of my regular readers will notice that his views differ from mine on some points and match mine on others, but all the positives and negatives help build the case for the Muddle Through Economy and that is why it is this week's Outside the Box.

John Mauldin, Editor
Outside the Box

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Making the Bull's Case and the Bear's Case
Perception for the Professional - "View from the North Country"

Why I'm A "Nervous" Bull

I suspect we are in the latter stages of the current cyclical bull market, a view that is also shared by two market strategists I very much respect. Based on Leuthold Group studies of typical historical cyclical bull markets, in terms of magnitude, duration, and valuations, it seems late in the game.....IF the current bull market is "typical". And yes, that is a big "if". It is certainly possible the current cyclical bull market may last longer and be stronger than the typical (median or average) bull market 1900 to date.

In terms of valuation benchmarks, we view the stock market as overvalued when compared to historical norms. This is based on the composite reading of the 39 valuation measures monitored by The Leuthold Group. However, the current degree of overvaluation pales when compared to some past extremes like 1999-2000 or 1987. Yes, an overvalued market can and has become significantly more overvalued. Today, we estimate that a regression to stock market historical valuation medians implies a 15%-17% decline from February month-end levels. At some past bull market peaks, this estimated downside calculation has been twice that. In summary, our historical comparisons of duration, magnitude, and valuation are what make me somewhat uncomfortable with this market.


I believe in numbers and disciplines, but most readers like to see explanations and reasons.....at least this is what our marketing and client service people say. So, herein I will comment on many of the current stock market positives and negatives being discussed by clients and Wall Street strategists.


  • The U.S. and global economies continue to grow and prosper.
    .....So far in 2005, U.S. economic growth appears stronger than expected, with Capex especially strong, although consumer spending is slowing somewhat. Other than Japan and Germany, global economic growth is also strong. However, oil prices and rising interest rates could be a drag later in 2005, as the Fed grows increasingly concerned about inflation. Typical post WWII economic expansions run about 4 years, although the two latest U.S. expansions were of record length (8-9 years). I might note the current expansion will be 4 years old in late 2005. Will the current expansion be typical or extended?.....That is the question. Also, keep in mind the stock market turns down 6-7 months before the economy. If the current expansion is "typical", the stock market could peak in the next few months.
  • Earnings are expected to grow at least 10% in 2005.
    .....Analyst first quarter earnings estimates for S&P 500 stocks (up 7.5% year over year) appear to be low and earnings could be up 15% in Q1 (stronger than expected economy and continued record high profit margins). But, I expect margins to contract in the second half of 2005, considering rising labor, materials, and energy costs. Still, I think analyst earnings estimates for 2005 will jump after Q1 strong results. But, the second half could disappoint. Overall, the current 10% earnings growth expectation for the full year may turn out to be about on the mark.
  • Interest rates may move up a bit, but will remain at historically low levels.
    .....The bulls concede that short rates will rise with Greenspan's baby steps, but Fed funds at 3.5% or even 4% would not be high enough to restrict the growing economy. In addition, most now think interest rates, be they short or long, won't be high enough to pull investor money away from the stock market, nor high enough to attract currently uncommitted funds into bonds rather than stocks. However, I see long term rates moving up more than most now expect, particularly in the second half of 2005, with higher rates driven by inflation and deficit fears. Rising mortgage rates could cool the still red hot housing market, especially if combined with tighter mortgage lending practices. It may also be that economic stimulation coming from mortgage refinancing will no longer be a bullish factor.
  • There is still a lot of sideline money available to go into the stock market.
    .....I agree. Even though reported mutual fund cash is low, the public still has a pile of reserves in money market funds and savings accounts. This might be invested in U.S. stocks. Last year, investment in U.S. focused equity funds was the lowest since 1995, with fund investors even more cautious in Jan-Feb 2005. (The only strong inflows in 2004-2005 have been into foreign funds.) The key question of course is what will it take to renew the public's investment confidence in the U.S. stock market? Memories of the 2000-2002 market debacle have yet to be effectively excised.
  • The technical underpinnings of the U.S. stock market remain strong.
    .....Our work confirms this, with the combined reading of the Major Trend Index Momentum/Breadth/Divergence category still positive by 657 points. While there has been deterioration in a few of the Breadth measures in 2005, the Momentum measures have certainly improved recently. The catch here is that the complexion of stock market technicals can change quite rapidly.
  • Corporate balance sheets are typically in great shape, loaded with cash.
    .....The implications here could be cash acquisitions of other companies, stepped up share buybacks, increased capital spending, and dividend increases. All can be considered as bullish factors for the stock market. I might add that most companies remain pretty stingy when it comes to dividends and there is surprisingly little pressure from investors to increase dividends, especially considering the lower tax rate. Acquiring other companies for cash carries the risk of over paying, while share buybacks, rather than shrinking capitalizations, are often employed to reduce potential dilution from stock option issuance.
  • Expected improvement in trade deficit would be a market positive.
    .....This now appears to be happening and it should be a positive for GDP growth, as well as alleviating some investor fears regarding a further deep decline in the dollar.
  • The Fed is expected to remain accommodative in 2005 and perhaps longer.
    .....The Fed's widely publicized upside baby steps policy with the Fed funds rate is not expected to put a damper on the economy this side of 4.5% (a level I consider neutral). But, I might note that money supply growth seems to be slowing and may now be closer to neutral territory than the Fed funds rate at 2.5%. However, these days the Fed seems to be somewhat more concerned about inflation and the housing bubble. The current accommodative stance may not endure for as long as the bulls now believe (slowing money supply and possible real estate lending modifications).
  • Inflation remains tame, and is expected to remain so in 2005.
    .....I have my doubts about this, expecting the CPI annual rate of change to rise to 3.8% by year end 2005. Also, keep in mind we strongly believe the CPI understates the degree of consumer-experienced inflation. While 3.8% CPI inflation may not in itself be viewed as dangerous, the trend may be ominous, particularly for bond investors and subsequently for equity investors. Of all the bullish factors cited herein, I think this is the most suspect.


  • The economy could cool off significantly late in 2005, with a recession on the horizon.
    .....This is certainly possible, considering that the typical economic expansion since WWII is about four years (we are now in the fourth year). Extended economic expansions (Reagan, Clinton) are historical exceptions, not the rule. Since the stock market typically peaks out about 6-7 months before the economic cycle tops out, 2005 could see a bull market peak. Nevertheless, as previously noted, the economic expansion still appears to be very healthy.
  • This cyclical bull market is mature in terms of magnitude and duration.
    .....I discussed this earlier, but based on historical cyclical bull market averages and medians, it may be late in the game. Those who believe in a four year stock market cycle would agree. But keep in mind, when calculating the bull market medians in terms of duration and magnitude, 50% of the occurrences are longer and stronger than the median.
  • The stock market is currently overvalued by historical valuation measures.
    .....As previously noted, this is true when measured against The Leuthold Group's historical benchmarks. But, this in itself is not sufficient reason to be bearish. As also noted, a stock market that is somewhat overvalued can continue to move higher and become grossly overvalued. The current level of overvaluation is not yet extreme.
  • Current profit margins at or close to record levels are bound to contract.
    .....I pretty much agree. Rising labor costs, reduced productivity gains, higher material and energy costs, and increased price competition are likely to combine and reduce profit margins in the last half of 2005. Thus, 2005 aggregate earnings gains seem unlikely to exceed revenue growth, and may in fact lag top line growth.
  • The rise in interest rates will be more than expected and do more damage.
    .....I agree with this bearish factor. I see the negative drivers being rising inflation fears, growing budget deficit concerns, and perhaps the unwinding leverage of carry trades by banks, hedge funds, and other speculators. Our six month target for 10 year Treasuries is 5.10% with a 12 month target of 5.50%. For 20 year Treasuries, the targets are 5.50% and 6.00%. (In a major carry trade liquidation, our targets may well be too low.) Bond yields approaching 6% could pull investors away from the stock market and do major damage to the residential real estate boom we are now experiencing.
  • High inflation or fears of high inflation could kill this bull market.
    .....As previously noted, we do expect higher inflation later in 2005, but the year over year change in the CPI may actually be declining in the first half of 2005, as Jim Floyd explains in the "Inflation Watch" section. Nevertheless, later in 2005, inflation fears are expected to be on the rise, traditionally a disturbing factor for bonds and for the stock market.
  • Continued rising oil prices and supply shortage would clearly be a bearish factor.
    .....I didn't expect to see crude prices much above $55 in 2005, nor do I expect shortages.....unless a new Middle East geopolitical crisis develops. Much of the 2004 rise in oil prices was the result of the decline in the dollar, and I don't expect to see the dollar swoon repeated in 2005. While crude prices in the $50 area in 2005 would retard U.S. economic growth, this would not in itself kill the economic expansion or cause a bear market. We are slowly adapting to higher energy costs and this process will accelerate in 2005 and beyond, providing real growth opportunities for companies involved in conservation and energy alternatives.....such as nuclear power.
  • A new round of dollar weakness would be damaging for the U.S. stock market.
    .....Perhaps it would, but I don't expect a new major decline in the dollar. I continue to believe the dollar will strengthen against the euro in 2005. When compared to Europe (not Asia), the U.S. has a much stronger economy. In addition, our current fiscal difficulties are certainly no worse than the dominant countries in the EU that first violated and then discarded their GDP related deficit disciplines. And, for that matter, Europe's government sponsored retirement programs are typically in even worse shape than our Social Security System. Thus, I think the euro is probably now significantly overvalued relative to the dollar.

    However, I am not so optimistic when judging the dollar against Asian currencies, because I expect the Yuan will be revalued upward, if not in 2005, likely in 2006. (Ultimately, the Yuan could become the benchmark currency for a number of Pacific Rim countries). If I am correct about the Yuan revaluation, the dollar (while rising against the euro) would fall against the Yuan. Thus, considering the importance of trade with China, the trade weighted dollar may well move somewhat lower.
  • The U.S. huge trade deficit is bound to ultimately be a stock market negative.
    .....Recent reports indicate the trade deficit may no longer be growing in what appears to be a delayed reaction to the dollar's 2003-2004 decline. Anyway, I think the significance of this trade deficit is exaggerated, at least in terms of its potential negative impact on the U.S. stock market. Some claim that whenever a country's trade deficit has exceeded 5% of GDP, it has been big trouble. This may be true for smaller nations, but it can hardly stand as precedent for an economic super power like the U.S. Within a year or so, China will probably delink the Yuan from the dollar (an Asian prestige thing?), and that should also help our trade balance. It would also help if the price of crude oil retreats from its peaks. However, the U.S. trade deficit could become a major stock negative if it causes our government to erect strong protectionist trade barriers and tariffs.
  • The 2005 Federal budget deficit is likely to rise rather than fall.
    .....By now most readers should be aware of my concerns regarding the lack of fiscal responsibility being demonstrated by our politicians, both Democrats and Republicans. Even with government revenues increasing with the strong economy, the fiscal 2005 deficit could exceed fiscal 2004's, thanks to a requested increase in appropriations for Iraq, Afghanistan, and homeland defense. I might also note the administration's stated goal of cutting the deficit in half by 2009 includes the wishful assumption that the current economic expansion will run at least nine years (compared to a post WWII average of about 4 years). Republicans still maintain their reputation as tax cutters, but they have now also been transformed into big spenders under the leadership of "no veto" Bush. I doubt that even a 20 year business expansion would bail the country out of the deficit hole dug with the policy of guns, butter, pork, and tax cuts.

    The administration's plan for privatizing Social Security would add $1.2 trillion to the deficit (as estimated by the Concord Coalition). Also according to Concord, other proposals put forth by Bush during the campaign would increase the deficit by another $1.3 trillion over the next ten years. (Let's hope Bush was just kidding.) Consider also what is already on the books. The soaring Medicare costs, including prescription drug benefits are offset by only about 1/3 with the 2.9% payroll tax and combined with the premiums collected on the Part B Medicare supplement. Compared to this health care entitlement program, Social Security is in top financial shape.

    You may recall when some Pollyanna's maintained deficits didn't matter because we just borrowed from and owe money to ourselves......Well, not anymore. The deficit will become a major stock market negative sooner than most expect.
  • There will be more and bigger hedge fund blowups hitting the markets.
    .....I expect we will see more and bigger hedge fund debacles in 2005, as managers stretch their risk parameters attempting to put up more enticing performance numbers. This has become an overcrowded and still mostly unregulated industry (if we can call it an industry). New money inflows into hedge funds declined some in 2004, and my guess is this trend will accelerate, particularly if the "blowup stories" multiply. The most vulnerable funds (other than the frauds) are likely to be those who engage in very high leverage carry trades, particularly those with long positions in lesser quality credits. However, I think it is unlikely that hedge fund blowups can cause a bear market in stocks, perhaps a sharp market decline, but not a new bear market. My guess is the fixed income markets may suffer greater damage than the stock market.
  • There is the continuing risk of terrorist attacks and a new Middle East offensive.
    .....This has been an obvious stock market risk since 9/11, but it is a factor that defies evaluation or anticipation, at least from my standpoint. The Iraq election was a positive development and further U.S. extraction from the Iraq quagmire would seem to be a bullish factor. If the U.S. embarked on a new "go it alone" anti-terrorist offensive against another country, I could see the stock market responding quite negatively.....unless it was an immediate response to a major terrorist attack on our shores. A terrorist event of 9/11 magnitude would crater the market, but I would probably consider it a buying opportunity.


I hope you enjoyed the market comments made by Steve Leuthold this week. You can find out more about his organization at www.leutholdgroup.com.

Your Muddle Through Economy analysts,

John Mauldin

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