The Great Global Bull Market
Since the global selloff triggered by the draining of Japan’s Monetary Base
ended in July, stocks worldwide have been in a strong bull market.
Emerging Markets, an asset class that was hit as hard as commodity stocks
in May and June, have led the rally, and India has been near the front of the
pack. (Until now, North American investors have not had convenient
investment vehicles for accessing the Indian stock market, but Barclay’s has
announced a new iShare that simulates the Indian MSCI, and mutual fund
organizations have announced their intention of creating India-only funds.)
We shall be writing more extensively about investment opportunities in
Indian securities next year, but for now we wish merely to consider whether
this broad-based global bull market is soundly based.
Among the reasons cited by pundits and strategists for the runup:
• Inflation has probably peaked in the US and remains at remarkably low
levels across most of the Third World. Europe, where inflation rates
lagged the US and some other leading economies, is now catching up,
but Jean-Claude Trichet and his colleagues are vigilant, and Eurozone
inflation will surely peak soon.
• Bond yields on longer-term government issues never really rose much
during this greatest-of-all global economic recoveries, not even in the
US, where the Fed quintupled the fed funds rate.
• Riskier bonds—corporates, junk, and Emerging Markets—solidly
outperformed Treasurys and other sovereign credits, and yield spreads
have narrowed almost to the vanishing point. The bond market is
screaming that this is becoming a virtually riskless world—so stock
prices are bound to go higher.
• Bond investors’ appetites for low-quality corporate paper provide serial
bonanzas for private equity firms and hedge funds. The junk bonds that
are such a huge component of private equity buyouts are, for the first
time in the history of this asset class, a significantly cheaper source of
capital than equities. Result: value stocks are disappearing from public
stock markets into private maws. Shareholders of the acquired
companies rush to redeploy their funds, providing never-ending cash
flow for equity markets.
“Emerging Markets...
have led the rally, and
India has been near
the front of the pack.“
• The global economy just keeps growing, despite high oil and metal
prices, sustained tightening by central banks, revelations of corporate
excesses, the War on Terror, Iraq, Lebanon, etc. What began to look like
a bull-slayer was the housing bubble, as house prices soared worldwide.
Those bears who gained great followings by growling in 2004-5 that the
housing bubbles would trigger recessions and commodity collapses
(first in Britain and Australia, and then in the US) are having trouble
maintaining their credibility. Some day, Stephen Roach, Alan Abelson et
al. may be proved right. But being bearish long before most stock
markets (other than, of course, Nasdaq) hit new alltime highs is good
neither for their reputations nor their followers’ performance numbers.
• Although the world’s central banks have been in tightening mode for
the past two years, global liquidity remains robust, and continues to
gush with Amazonian force into global financial markets. American
corporations hold record amounts of cash, maintaining caution about
capex commitments. Bear markets tend to come when credit demand is
soaring amid liquidity drought conditions, not amid floods. We have,
at least for now, the perfect conditions for equity price inflation: too
much money chasing too few publicly-traded stocks.
• Although most US persons who own at least $10,000 of stock have
voted Republican since the Reagan era, the profile of the super-rich,
including nouveaux riches billionaires, is sharply different. The
Democratic takeover of Congress was therefore considered good news
by the majority of those who own and/or manage hedge funds, at a time
when small investors were feeling disenchanted with Republicans
because of runaway spending, Iraq, Foley's Fancies, and the kind of
corruption they had long associated with Democrats. Result: the
Democrats’ win was taken as a reason to buy stocks—the exact inverse
to the way the investing community had long responded to American
election results.
• Corporate profits continue to improve, and p/e ratios in most stock
markets remain reasonable.
• Oil prices have apparently peaked. There’s now lots of talk of $45 or $50
oil and nobody seems to be talking about $80 oil anymore.
• As more and more people near or enter retirement, there’s increasing
recognition that fixed income is a weak reed for retirement planning. If
December
long Treasury yields had trouble getting to 5% when oil was $65, US
CPI was 3.5%, GDP growth was 3% and unemployment was 4.8%, then
bonds can hardly be the cornerstones of a retirement that could last
three decades or more. Result: the middle class investors who have the
most money to invest—the middle-aged and mid-Sixties—are going to
be sticking with stocks longer.
• This is the first cycle in which US investors with modest and moderate
means have been investing heavily abroad. In part, the record outflows
into foreign markets reflect the falling value of the dollar. However, the
major factor has been the sustained superior performance of foreign and
Emerging Markets compared with the US. That has influenced the
marketing strategies of the major firms managing 401(k) accounts and
financial planners serving individual investors. The mushroom growth
of ETFs has made investing in foreign and Emerging Markets cheap,
compared with the management fees leading US organizations long
charged their clients. For some foreign markets—such as India—the
cash flows from US retail investors have been significant in driving those
markets to record highs.
• Although the rise of China and India scares workers and leftist political
elites in Europe and America, investors worldwide are taking a more
relaxed view. They see the powerful economic growth in those countries
as a reason for buying stocks of companies that benefit from a
continuation of the global economic boom, even though they assume
American growth will be more subdued. Jacques Chirac, Lou Dobbs, Pat
Buchanan and Nancy Pelosi may moan that free trade means that Third
World countries will destroy the established economies of the industrial
world , but most investors—including, it would appear, most European
and American investors—see it as the engine of greater prosperity.
• The bad news is that because of that rising strength of protectionism in
Europe and America, the two decades of progress toward freer trade
kicked off by Reagan and Thatcher is running out of both supporters
and steam. The Doha Round is stalled, and the pattern of country-tocountry
free trade pacts that Bush was able to secure is dead. The
emerging Democratic leadership is deeply protectionist. For example,
the seemingly moderate and progressive Barack Obama has voted
against all Bush free trade initiatives—even free trade with that terrifying
threat to the American economy, Costa Rica. However, the good news is
that because of WTO, NAFTA and the other recent landmark trade
treaties, world trade in goods and services is freer than it has ever been,
and the attempts by the far Right and far Left to resurrect Smoot-Hawley
will fail.
Those are the bullish arguments for stocks that have coalesced in recent
weeks to give spirited rallies. We are in agreement with those that relate to
the positive outlook for inflation, the global economy, and global equity
markets. We admit that we underestimated the powerfully positive impact
of private equity activities on the US stock market. We are also somewhat
surprised that global liquidity remains so plentiful, despite the two years of
restraint by central banks. What we underestimated was the huge flood of
petrodollars into major bond and stock markets after the collapse of the
stock markets in the Arabian Gulf. Although the Eurozone and the
London bond and stock markets have been the biggest beneficiaries of this
petrogush, these are also the markets—along with China and Hong Kong—
where nearly all the big-ticket IPOs have been floated. That has meant that
the US stock market has benefited from the shrinkage of equity supply due
to buyouts and takeovers, without having to absorb gigantic infusions of
IPOs.
We see this change in the financial underpinnings of global equity markets
as an historic shift. Treasury Secretary Hank Paulson—who should know—
is very worried, and very frank, about the change in New York’s global
ranking. Sarbanes-Oxley, Eliot Spitzer, and America’s global pre-eminence
in the supply and sophistication of rapacious lawyers have combined to
make New York a relatively undesirable venue for IPOs. With the US
Current Account deficit at $800 billion and rising, issuers have naturally
begun to gravitate toward markets that are notable for their huge supplies of
cash and their tiny brigades of regulators, demagogues, and tort lawyers.
We would be the last to decry sensible attempts to clean up sleaze in
American equity markets. However, Sarbanes-Oxley’s highly visible
processes to make the invisible hand of capitalism work more honestly and
ethically have yet to prove that they are worth the trouble and cost.
The tech enthusiasm that metastasized to mania occurred when American
capital markets loved to brag that they were underpinned by the world’s
most thorough accounting practices. Those supposedly sound practices
helped put the imprimatur of soundness and prudence on what was actually
the greatest explosion of greed and financial chicanery of all time—the stock
option phenomenon of “free” awards of stock that were never charged to
company earnings statements. Only recently has it been disclosed that
hundreds of American companies—mostly techs—had been rigging the
option grants to guarantee profits for top insiders. Schemes that were said to
align top management’s interest with the stockholders’ were based on
backdating options, retrospectively picking low stock price points, so that
CEOs and CFOs could be awarded stock at prices already deep in the
money. The stock option system that was supposed to be a glory of
American risk-taking and entrepreneurship was—on a grand scale—what
the 1919 Chicago “Black Sox” were to that other great American game.
(Apple stockholder on reading of 40 million backdated options approved
by the CEO: “Say it ain’t so, Steve.”)
That we are now learning the extent of the fraudulence is not because of the
costly new rigors of our laws and regulations. The revelations came from the
work of a few academics and from the diligent research and reporting of The
Wall Street Journal—not from Eliot Spitzer, or from the Laocoönesque coils
of Sarbanes-Oxley.
Our reservations about high percentage equity exposure for American
pension funds have been based largely on our concerns about relative values
in the American stock market compared to valuations abroad. We know that
most American pension funds have historically been uncomfortable with
high levels of investment in foreign equities. Therefore, we have suggested
low commitments to total equities as America works its way through the
long recovery from the recession caused largely by the Triple Waterfall Crash
of technology stocks, 9/11, the unfolding stories of slime in the suites, the
War on Terror, Iraq, the Current Account deficit, relatively high valuations
of US equities compared with many foreign markets, the dollar propped up
by “The Great Symbiosis,” and a corrosive political climate in Washington.
We have recommended that clients hold below-average equity exposure,
while heavily overweighting commodity stocks, foreign equities, Emerging
Markets, and the group of blue chips we have called The Great Dividend
Payers.
That strategy has delivered portfolio outperformance for most of the past
four years. In particular, investors owning commodity stocks with the
attributes we emphasized, such as Inco, Falconbridge, Phelps Dodge, Teck
Cominco, Suncor, Canadian Oil Sands, Glamis Gold, and Barrick have been
rewarded.
AI
