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January 26, 2007

Bears Wait for the Dam To Break
by Brady Willett

Before embarking upon another assault against the liquidity forces that be, it is worth recognizing that the remaining bears in this world have done well despite the fact that their macro beliefs have proven untimely. To be sure, 'bears' (or value investors) that purchased select stocks during the current bull market have produced acceptable returns, bears with precious metals exposure since the 2003 liquidity-fest started have done exceptional, and bears that reduced their exposure to the U.S. dollar along the way have outright thrived. As bullish market prophets lob verbal bombs into the bears' camp claiming that since equities have performed well the bears must be bleeding, these are important points to remember. After all, being 'bearish' on most stocks doesn't necessarily mean that you are heavily shorting stocks. Being bearish and being foolish are two separate matters altogether.

Yet as prosperous as many bears have been in recent years, there is nonetheless the uncomfortable reality that bubbly asset price movements have attacked and undermined the bear case. Moreover, there is the possibility that the bear case is flat out wrong, and that the financial markets have evolved and entered a new epoch of potency. Economists have coined this 'evolutionary' trajectory 'The Great Moderation'; which basically contends that there has been a permanent reduction in macroeconomic volatility (Bernanke). Most recently the Times picked up on this theme, claiming that "Historians will marvel at the stability of our era". Forgive us for equating these types of phrases with 'stocks have reached a permanently high plateau', but the temptation is simply too great.

Ironically, even some notable bears have started to tinker, albeit quite loosely, with the idea that the global economy and financial markets are in a 'new' paradigm. Most notably, Stephen Roach, who briefly turned bullish last year, questioned his stripes even further in a recent commentary:

"For longer than I care to remember, my base case has argued that ever-mounting imbalances will ultimately crimp vigorous growth in the global economy. While there can be no mistaking the imbalances of a US-centric world, there can also be no mistaking the extraordinary resilience of the great global growth machine. Is it time for a new approach?"

Have Bears Lost Their Center?

With the VIX resting near all-time lows, the S&P 500 not having corrected by even 2% in the last 6-months, and weakness in one asset class (i.e. US housing) simply padding expectations for spectacular gains in other asset classes, it is difficult for pessimism to build in the marketplace. For that matter, with some very basic valuation measures (namely trailing operating P/Es) not exactly screaming mania, it is difficult to point to traditional overvaluation models to extol doomsday scenarios. Suffice to say, as their forecasts prove inaccurate bears have had to resort to less conventional platforms to build their case, including contrarian analysis of dovish credit spreads, potential yield curve demons, and the oft-used conclusion that there is 'excessive liquidity' in the marketplace.

But while on the surface it would appear that bears have simply been hopping from one sinking platform to the next, whether theorizing of an inflationary shock, an emerging market blow-up, a collapse in housing prices, or a systemic hedge fund default, the macro conclusion from bears is much the same: a yet unknown catalyst is destined to arrive and expose many of the unsustainable imbalances in the world. These 'imbalances' include, among others, the burgeoning US trade deficit, the negative US savings rate, and the overall increased reliance of many economies on the performance of asset prices.

Suffice to say, while 'The Great Moderation' talks about new smoothing mechanisms at work in the financial markets and new policies/global interlinkages that have helped steady the global economy, bears are less concerned with the last 20-years of harvests and more concerned with the seeds that have been planted. Indeed, economic growth that is powered in large part by rising asset prices, inflationary monetary policies, and debt creation may produce the picture of strength, but it also causes the shadows of unsustainability to intensify rather than vanish.

Conclusions

"If the great global growth machine doesn't start to slow by the end of this year, it'll be high time to give up the ghost." Jan 16, 2007. Roach

With long-term bears like Richard Bernstein recently changing teams, and analysts like Roach attaching their convictions to a timetable, it can be speculated that we are nearing the point of universal bullishness. The bears that still exist today should remain cognizant of this trend, and also of the fact that as more people clamor into hedge fund hallways and volatility becomes more widely accepted as a barbarous relic of an unsophisticated financial past, the bear case strengthens rather than weakens.

That said, the exact point wherein the bears synchronize their macro beliefs with the prevailing reality remains largely a mystery, and with investor risk tolerance tests at or near all-time highs Sherlock Holmes himself is left to scratch his head. Indeed, those who need a lesson in just how senseless things can get should recall the late 1990s. After the Asian Crisis and LTCM blow-up many, ourselves included, believed that an equities bust and US economic slow down had been triggered, but in 1999 the Nasdaq gained 85%! For the record, being bearish in 1999, even as the Nasdaq and other indices soared, proved to be an excellent idea, although at the time the exodus from camp bear certainly made those who remained feel a little bit lonely.

"If you need a friend, get a dog." Gordon Gekko

Being wrong about short-term movements in stock prices is not the same thing as losing money. Those that did well in the late 1990s as well as in 2000, 2001, and 2002 (three devastating years for stocks) were those that never bought into the idea that stocks were in a new paradigm, and those that will likely do well in the years ahead are those that chose not to chase rising asset prices today.

In short, with precious metals, equities, bonds, and cash (non USD) all performing strongly in recent years, almost everyone has profited...but only one animal is prepared for the potential damage that excessive liquidity in the marketplace can unfurl. As bears wait for the great liquidity dam to break, the bulls pour concrete angels around the 'Great Moderation' and hope that this time things remain different.

Brady Willett
FallStreet.com

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