US Economy and Stock Market Continue Rising – Bears Out on a Limb

Tuesday, April 6, 2010

I have been writing for some time about economic improvements and attractive US stock valuations being bullish. Today, I want to shift gears and take a look at the bearish case – six reasons that bears dismiss the economy’s health and stock valuations. And why they view the economy and stock market as being at risk.

1. The US stock market’s rise means higher risk

The argument is that last year’s major problems remain, and attempts to cure them have failed. Therefore, today’s higher stock prices mean a larger drop tomorrow.

This argument requires a “frozen” mindset in which last year’s problems retain their size and probability. In actuality, they have diminished or dissipated in key areas.

2. Bad conditions will return

A similar bear argument is that the recent positive results come from a temporary growth period caused by easy money, incentives and stimulus payments. As this growth peters out, negative trends will reassert themselves, reversing the growth and driving earnings and stock prices down. Therefore, the reasoning goes, stocks are not attractively valued – they are overpriced and destined to fall.

This hypothesis cites the same negative factors that caused the original problems. The twist is that they haven’t been permanently cured, but are simply papered over and soon will burst out anew. However, in the economic/investment world, as in nature, lightening rarely strikes twice in the same place. Why? Because once everyone knows the risks, all take evasive measures. And, most importantly, all investment prices now include the risks.

3. Problems are too big to be solved quickly – if at all

The reasoning is that things became so quickly and significantly unglued and broken that it will take years to make the repairs. And perhaps the fallout (like permanently reduced consumer spending) will prevent total repair.

The flaw is the presumption that a fast and deep drop must be followed by a slow and shallow recovery. There are simply too many factors, forces and relationships to make such a prediction.

4. Stock valuations (i.e., price/earnings ratios) are dangerously high

I put this in the “lying-with-statistics” camp because these bears use last year’s earnings to make their calculations. In investing, prices are always based on tomorrow – never on yesterday. Imagine the reverse argument after October 2008’s stock market drop.

5. Earnings are unreliable

The concern here is that accounting gimmicks allow presenting a false earnings picture.

The truth is, in the US there are strict accounting rules that prevent gimmickry. In addition to the rules, experienced analysts pour over the earnings reports, making adjustments as needed to develop a true picture of a company’s operating earnings.

6. Wall Street cannot be trusted

Here, bears say earnings forecasts cannot be trusted because they come from Wall Street. Well, yes they do. But, “Wall Street” in this instance means experienced analysts (wherever they live and work) tracking selected companies, pouring over voluminous company data and getting firsthand answers to their in-depth questions.

The “Wall Street” label, always pejorative following a bear market, is a positive when viewing earnings forecasts. Analysts build their careers by developing a reliable reputation for better foresight – not by faking out investors. Even if there is a bad apple in the bunch, the earnings forecasts we see are from the center of the pack, not the extremes. Therefore, we can use these forecasts to cut through all the details and get to the heart of what’s driving a stock or stock market – its future.

So… Improving conditions and markets have made the bears’ rationale weak. We can continue to accept economic measures and improvements at face value. And we can use Wall Street’s earnings forecasts in making judgments about US stocks.

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