I read with interest the recent debate between Doug Kass and Michael Comeau on the street.com. As a bear second only to Doug, I see the potential for a major drop in stock prices. But I’d agree with Michael that “sounding ‘last call’ now seems premature,” mainly because of timing issues. My best guess it that a combination of the U.S. presidential election cycle and the Chinese preparations for the 2008 Olympics will keep the wolf at bay for one more year. These and other positive drivers listed in the next paragraph won’t carry as much force next year, so I’ll have to revisit the bear case then. My views could best be summed up by saying, “stocks will soon fall, but not this year.”

Things are still good for now, but it’s also hard not to see the handwriting on the wall. Earnings growth still appears to be strong, but it figures to weaken during the course of 2007. The Fed is probably done tightening, although other central banks may have just begun. The U.S. housing market appears to have stabilized for now, but the ARM resets are beginning in large numbers this year. A number of elections took place relatively peacefully in Latin America and elsewhere in the developing world last year, even in Venezuela, although the winners of some of them are now starting to rattle the cages.

There are two mean reversion arguments regarding valuations; that U.S. stocks are fairly valued today, relative to trend or as Comeau put it, “stocks today are not terribly overvalued,” and that stocks are well above trend. These arguments are equally valid—depending on which time frame you use. The first applies in comparison to the past ten years or so. The second, and “Kassian” argument applies over a whole “long cycle” of 30-plus years, consisting of a depressed decade between 1975-1984, a middling decade from 1985-1994, and an exuberant decade of 1995-the present. What has happened in past bear markets is that there is a catalyst that yanks stock prices out of their ten (plus) year trend, and toward (and even below) their 30-year trend line. 

When I published my year-end piece saying that the bulls were “on serve” because markets almost always go up the year before a Presidential election, Doug then emailed me “Et tu, Brute,” thus accusing me of deserting him. Fair enough, but he hadn’t been making the argument that would have kept me in his camp in 2007. His call for lumpy, mediocre growth,” 1970s style (which I endorse), is a bearish argument, but one that doesn’t cut it in a pre-Presidential election year; 1967, 1971, 1975, and 1979, the analogous years of the last secular bear market, were all up. The real bear argument is that 2007 will shortly become the modern 1931. If that’s the case, the market will go down this year, pre-election year or not. 

As arguments go, I would describe his hypothesized collapse in commodity prices (if it occurs) as “warm.” But that would not be the real danger in and of itself. Major market reversals usually start in the banking system. Remember the 1980-81 oil bust and what it did to banks like Continental Illinois. The bear case is that an Asian banking crisis (perhaps driven by a commodity bust) will put a kibosh on the global growth story. The scariest piece of global economic news I've read recently is that Korean banks were taking a hit on bad construction loans. This could have a ripple effect on the banks of a much larger country, China, whose banks are equally shaky. In fact, the Chinese central bank is raising the discount rate to rein in torrid lending growth (much of which is real estate based).

So I’ve answered the three key questions of when (after 2007, perhaps 2008 or 2009), why (a catalyst such as an Asian banking crisis) and how (a reversion to, or through the thirty year mean valuation pulling stocks out of the ten year trend line). The timing of these events is anybody’s guess, but the more important thing to know is what to look for.

© 2007 Thomas P. Au
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Thomas P. Au
R. W. Wentworth
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