Philip Coggan: Even the bears are divided between two camps

Last week, I spelt out why the “new bulls” believe the future could be rosy for both economies and the stock market. In essence, they argue that the emergence of India and China is boosting output and profits while keeping the lid on inflation.

Now it is the turn of the bearish case. Their argument is based on the presumption that the excesses of the dotcom bubble have not been shaken out of the system. Shares may have fallen a long way between March 2000 and March 2003, but they never reached a level that could be called cheap in historical terms.

That is because the central banks stepped in to protect the economy by cutting interest rates. That seemed good at the time; a sharp recession was avoided, as was the kind of financial crisis that was associated with past bear markets. But the bears argue that this was the equivalent of a drunk having another beer to stave off a hangover; it may feel better in the short term, but in the long run the headache will be worse.

The bears believe central banks have simply stimulated another bubble, in the housing market, to replace the technology boom. Rising house prices have boosted consumer confidence and kept them spending, despite the loss in their equity wealth between 2000 and 2003.

In terms of where we go from here, the bearish camp tends to split in two. One half believes inflation is the inevitable result. Indeed, that group believes we are already experiencing inflation; it is simply not being picked up in the official statistics. They are contemptuous of “core” inflation measures that leave out vital items such as energy and food, and argue we should pay a lot more attention to asset and commodity prices, particularly gold.

The steady rise of the yellow metal is a sign, they believe, that investors are worried about inflation and are seeking safety in the one true source of value. Paper money, they argue, always depreciates to its intrinsic value; that is, nothing.

The Federal Reserve, the bears say, has consistently intervened to rescue markets when share prices are falling sharply but has refused to puncture bubbles, whether in technology stocks or in housing. The result has been the “Greenspan put”; the increased willingness of investors to take risks because they believe the Fed is underwriting asset values.

Eventually, the bears argue, high debt levels will overwhelm consumers. When it does, the Fed, under new chairman, Ben Bernanke, will allow a “helicopter drop” of money into the US economy. The resulting inflation will alleviate the debt problem but result in a collapse in the dollar and cause substantial damage to the portfolios of those invested in cash or bonds.

The other half of the bearish camp agrees that high debt levels are a problem. But they argue that central banks will prove powerless to stop deflationary forces, just as the Bank of Japan failed in the 1990s. The result will be a deflationary depression. This camp believes one should own government bonds and large amounts of cash, in case of a collapse in the banking system.

This is one problem with accepting the bearish argument; it results in two completely divergent investment approaches.

How do bears deal with the bullish arguments advanced last week?

They argue that equities may look cheap relative to bonds but this is faulty analysis based on a shaky theory and selective analysis of the data.

The so-called earnings yield ratio is a case in point. Why should falling bond yields be good for equities? If yields are falling because inflation expectations are lower, then forecasts for nominal earnings growth should be reduced. And if yields are falling because the economy looks weak, then expectations for real profits growth should decline as well.

Andrew Smithers of the consultancy Smithers & Co says the only useful valuation approaches are the Q ratio (which compares share prices with the replacement cost of net assets) and the cyclically-adjusted price-earnings ratio. Both make equities look expensive.

As for the recent profits rise, the bears argue this is more cyclical than structural. At the top of the cycle, one should be paying lower-than-average valuations for equities, not higher.

On the role of India and China, the bears tend to divide. Some see the Asian story as the latest of the “different this time” arguments that regularly lure investors into overpaying for assets; others see Asia as the force that will cause the eventual deflationary bust.

So how can we compare the two arguments? I think there is merit in the case that easy money has been pushing up the prices of financial assets; why else would gold, index-linked gilts and emerging markets all be going up?

These benign conditions may not last. Mervyn King, the governor of the Bank of England, worried in a recent speech that the low level of yields was unsustainable and could lead to disruption in financial markets.

The governor was non-committal about the timing and this remains a problem for many of the bearish arguments; people have been warning about the risks of high debt levels for a very long time, without an apocalypse occurring.

Nevertheless, before we reach the paradise foreseen by the bulls, I find it hard to believe there will not be a significant market setback. And that is why investors should keep plenty of cash in their portfolios.

philip.coggan@ft.com

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