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.

History Lesson From the 'Twenties

Courtesy Barrons

 

Most of the article blames the government for policy mistakes.  Fair enough, policy mistakes were made.  But at a fundamental level, it was the misguided, misinformed opinion of the politicians - probably in connection with big corporations - that they are more potent than the business cycle and possess the tools to create immediate, ongoing prosperity. 

In many ways, the approach we are taking today reminds me of the same sort of thinking, that QE, bailing out the banks, creating huge amounts of debt will leave us better off.  Somehow, history suggests that this time will not be any different.  My core principle "you cannot fight your way out of a debt crisis by issuing more debt".

 

EIGHTY YEARS AGO THIS WEEK, THE U.S. economy took its first step into the abyss. Variety magazine headlined it as "Wall Street Lays an Egg." Barron's headlined with "Severe Liquidation on Thursday Stemmed by Banking Support; Subsequent Rally Followed by Orderly Decline at End of Week."

The severe liquidation of Black Thursday, Oct. 24, 1929, continued into the next week. By the issue of Monday, Nov. 4, Barron's was reporting "one of the most cyclonic breaks in the history of Wall Street." From the peak of Sept. 3, when the Dow Jones Industrial Average reached 381.17, the decline totaled 151.1 points on Nov. 4. "In barely seven weeks, the price gains of more than a year were swept away."

In neither Variety nor Barron's was there any apprehension that the Great Depression would follow the stock market.

In November 1929, Hoover took an active role in protecting the economy. He met with industrialists and union leaders and pushed them into a deal: Industry would not cut wages. Unions would not strike. If there wasn't enough work, jobs would be shared rather than prompting layoffs.

Hoover believed high wages were the key to prosperity. For employers, he created policies that allowed firms to cooperate in order to avoid "cut-throat competition" for labor.

On the labor side, Hoover signed the Davis-Bacon Act forcing local governments to pay union wages on public works and the Norris-LaGuardia Act outlawing injunctions against strikes and picketing.

Hoover's policies did what they were supposed to do: By late 1931, real hourly earnings in manufacturing had increased by more than 10% (adjusted for deflation of prices). Yet manufacturing hours worked had declined by more than 40%, even more than total output, which fell about 20%. By the end of 1931, the general unemployment rate was 15.9%, and it would get still worse for two more years.

Ohanian calculates that under Hoover's wage-support program, which trickled down from large businesses to small, the prevailing industrial wage rate was as much as 40% higher than the wages job-seekers would accept. Too many workers chased too few jobs that paid too much, and the result was men lined up around city blocks to apply for jobs.

The Hoover policy was more cooperative and voluntary than the mandates of the New Deal's National Industrial Recovery Act, but they were the same anticompetitive, price-fixing policies.

While generations of Americans have blamed Hoover for relying on the free market instead of government intervention, some of the workers' misery in the Great Depression should be attributed to Hoover's mistaken high-wage policy.