Seeking Certainty Is Way Too Risky
08/31/09
This has to be the most hated bull market in history. The market is successfully fulfilling its function of frustrating the majority of participants. Skepticism and doubts about the government's ability to rescue the economy have become common place on Wall Street, yet the stock market continues to act as if not only the worst is over but as if the economy is already taking off again. I have never in my carrier encountered so many ideologues posing as traders or investors. Not even the bulls and optimists were totally convinced that the stock market “should take off” like it did. But see, that's exactly it: The market took off because the majority of participants superimposed their moral, sociological or political doubts on the stock market and forgot about the real factors that are driving it.
The moralists were still clinging to the notion that people who went into debt and could no longer pay principal or interest should suffer the proper consequences. A “Bailout nation” (like the one run by Bernanke and Obama) rewards that kind of behavior and therefore belongs into the same category as those parasitic borrowers.
The sociologists pronounced that the consumer was too shell-shocked to do much of anything, much less help himself. They argue that the aging (graying) of America as well as the diminishing size of the manufacturing sector along with trends towards a service economy (hamburger flippers) without “real products”, will turn this country into a decadent nation in decline. At this juncture, sociologists and moralists meet and shake hands.
The politicos are much more direct and just claim that socialists like Pelosi and “Do-Gooders” like Obama ignore the necessities of the “real world” and impede this country's international competitiveness. Socialized healthcare and extension of unemployment benefits are typical agendas for Democrats on Capitol Hill, so they say. More social programs (in academia called “stabilizers” for a reason) will run the country into the ground, increase our indebtedness to foreign powers and eventually enslave the whole population.
All three categories of ideologues claim that the stock market and the dollar will eventually realize all this and crash. The stock market however refuses to go there. Why? It's all (and only) about the money, not about ideologies.
The above picture is supposed to replace a thousand words. Net cash flow and after tax profitability are twice as high today than they were in the fall of 1997, when the S&P 500 first traded up to 1020. Net cash flow stood at $858 billion then versus $1,548 billion today. After tax profits (for all private corporations, whether public or not) came in at $340 billion then versus $536 billion today. Both measures are also about 50% higher than in 2003, when the S&P 500 last traded around the 1020 mark. Does this look like the end of the world to you? Does this look like the cardiogram of a dying patient? The heartbeat is irregular at times, but that could be attributed to several growth spurts of an adolescent rather than the cardiac arrest of a dying man. So now that we have the facts out of the way, let us get back to the opinions of others, particularly the bears. Why then is this rally so hated? Perhaps investors want certainty, before they jump in. Perhaps they want to wait until unemployment drops below 9% before they feel that things are truly getting better? Or perhaps they need to be certain that house prices have risen in all parts of the country uniformly? Or perhaps they are waiting for the bank and credit card loans losses to have truly peaked? These people are angry because the market goes up week after week on murky and inconclusive data. They want certainty and the market is not giving it to them. I can't blame them after what we have been through, but if you want be a stock investor, certainty is your enemy, not your friend. Seeking certainty is way too risky. You just leave too much on the table. Look at the following measures of risk aversion.
Both charts show you the yield difference between BAA graded corporate bonds and 10-year government bonds. BAA corporate traded on 08/26/09 to yield 6.42%. 10-year government bonds traded on that day to yield 3.44%. The yield difference shown on the chart amounts to 2.98%. The greater the difference between the the two the higher the risk aversion of investors who bid up safe government paper and sell risky corporate paper. This series is one of the longest running measures of risk aversion and therefore gives us a pretty accurate picture of the mood in the capital markets. The first chart shows us monthly data going back to 1925. You can see that the crisis of 2008 drove risk aversion to extremes not seen since the great depression. You can also see that we just now are entering the range of normality below 3%, where the markets have resided throughout 70 of the past 80 years. Notice that yield differences above 3% constituted the height of the crisis in 1940, 1970, 1975, 1980, 1982 and 2002. We are just leaving that area now. Looking at the second chart, I suspect that the current drop in risk aversion will not stop until we have reached the 2% level. We may not get there in a straight line but I think we will get there. If we now survey the investment landscape we see that corporations have done an outstanding job of managing their cash flow and are already returning to profitability. Technology and a better understanding of the business cycle has certainly empowered the average business manager more than ever before. They do what it takes, quicker than ever before. That also may mean that they could shift from firing to hiring quicker than ever before. I think it entirely possible that we have seen the top in the U-3 unemployment numbers already. Lastly, this stock market is not reflecting a sick currency. If the U.S. economy experiences a real recovery next year, tax receipts will rise and federal outlays will begin to fall, the budget "crisis" will begin to pass and the rationale for a dollar crisis will pass along with it. That would anger certain bears even more than you can imagine.
Hermann Vohs
"If we insist on being as sure as is conceivable... we must be content to creep along the ground, and can never soar."
"We can believe what we choose. We are answerable for what we choose to believe."
John Henry Newman
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
