Sunday, November 1, 2009

Breaking Down the Bull Argument from David Dreman

This Month in Forbes by David Dreman :

Is Recession Normal? No
David Dreman, 11.16.09, 12:00 AM ET
Let's look more closely at the bear case. While it's true the market has had an enormous rally since early March, it is important to remember that it had fallen more precipitously than at any time since the Great Depression. The financial sector of the S&P 500, for example, fell 83% between June 1, 2007 and Mar. 6, 2009. This sector's decline was steeper than the overall market's decline between September 1929 and the 1932 low. So yes, this rally is strong and sharp, but remember that it comes off the worst stock market drop since the 1930s. It still hasn't really come close to recovering the ground it has lost. The Financial Select Sector SPDR Fund (XLF) is trading at 60% below its 2007 high.
So please don't judge the current rally in the context of typical market cycles. Remember, about a year ago our global financial markets were in a state of panic. If you check market history, you will see that the rallies following such panic attacks tend to be sharper and swifter.
As I point out in one of my previous posts, we agree that rallies are sharp and vicious off severe selloffs.  No arguments there.  But neither has the case for a new bull market been made yet by Mr. Dreman.

And please don't fixate on trailing price/earnings ratios. Multiples are inflated because earnings are depressed. It's that simple. We are in a severe recession, and hundreds of companies have ailing income statements.
Stock market investors aim to see around corners, and they should be doing that now. Corporate earnings will be down sharply this year (particularly if you include writeoffs), but they will rebound over the next three years. I can't tell you how quickly the recovery in earnings will come, but I am sure it will come. Go back to that market of 1932, when the Dow Jones industrial average bottomed out at 41.22. The Dow almost tripled within the next three years, even though it took earnings almost five years to catch up to where they were before the crash. In short, it's normal for stocks to rebound ahead of earnings.
Mr. Dreman is comparing the current cycle against the Depression.  Fine.  It took the market three years to bottom and during that time there was in fact a 50% rally.  But the market fell another 80% after that.  Further, the market did not get back to the levels of that initial 50% rally of roughly 300 on the Dow until 1954!  That is 22 years later Mr. Dreman.  Not a convincing argument that we are to look blindly into the abyss and trust that earnings will recover, debts will be repaid, valuations will catch up to the market.

I'd be more inclined to be receptive if the market exhibited characteristics of a bottom.  The market was overvalued compared to historical metrics at bottoms on Price / Sales, Price / Earnings, Dividend Yield.  Bottoms are also usually accompanied by hatred, revulsion.  Markets tend to die a slow death and then are born anew when no one is watching.  Granted we got revulsion from a section of the market, but market participants were frothing at the bottom. That by definition is not a true bottom.  I am not convinced by a long short.

The bears have a different view. They think the economic malaise will last for years or even decades, as in post-1989 Japan. Get used to a new normal in our economy, they say, one in which growth is sluggish or nonexistent for a whole generation. I say rubbish.

The great global investor John Templeton (1912--2008) said that the four most dangerous words in investing are "This time it's different." In more than 30 years of managing money I have witnessed many a shift in market sentiment. It lurches from irrational exuberance (as with tech stocks a decade ago) to irrational gloom (bank stocks in March). I just don't accept today's gloomy view.
In fact Mr. Dreman you're the one asking for blind faith and telling us this time is different, that the market can avoid historical characteristics of stock market bottoms, that we can issue mountains of debt to work off a debt crisis, that there is a fundamental loss of moral hazard, that the consumer is tapped, that Japan is in a debt and demographic crisis and will not assist in this recovery, ditto U.K.

Finally you Mr. Dreman are another child of the bubble in U.S. prosperity of the past 30 years and your automatic assumption, similar to Washington Politicians, is that the U.S. will revive because it has always done so in the past 30 years.

I would point you to this weeks Barrons article on the Depression.  Everyone underestimated the depth of the correction because there hadn't been a severe correction in over 20 years.  Ignore history at your own peril, Mr. Dreman.

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