The Speculator

By Victor Niederhoffer and Laurel Kenner

Atop the palisades overlooking a certain Southern California beach where Laurel spent many of her childhood days, a magnificent house perched at the edge of the cliff. Every year, the rains caused mud to slide onto the Pacific Coast Highway below, and the house lost a little more of its base. As the years passed, the gradual erosion of the hillside exposed more and more of the house’s foundation. One day, the house was gone.

A similar phenomenon has been taking place with the foundation and framework of the bear market in recent days. First to go were the technical supports—those that depend on such indicators as the price of the S&P 500 being below its 200-day moving average, a state of affairs that ended April 7. The market is now up 19% from its Oct. 9 low.

Also vanishing quickly are the braces for the bearish value boys. Most of them who attended college recently know that a company has a choice in distributing its earnings as dividends or buybacks or keeping the cash for future growth, and that the value of earnings is determined by the current level of long-term interest rates. How disorienting for them that the relation of projected earnings and bond yields—the so-called Fed Model, detailed below—shows stocks to be wildly undervalued.

We have nothing against bearishness in season, and have written a few bearish columns ourselves, starting at the end of 1999. In fact, with the market at new highs almost every day and sentiment as indicated by the CBOE’s Volatility Index highly complacent, we are in one of our more neutral-to-bearish stages right now. In our own speculations we do tend to swing from highly bullish to neutral, and we adjust our position sizes accordingly.

As we have repeatedly indicated over the past year, however, our long-term view is bullish. We said so most recently on April 10, when we introduced a forecast model based on secondary offerings, indicating a 19% rise in the S&P 500 in 2003. In our column of Dec. 27, 2002, we said that our best trade of the year would be to go long stocks and short bonds.

Our reasons for bullishness are pretty much the opposite of the bears’ reasons for bearishness. We feel that so much hope has been taken away from the market environment that the remaining holders are strong, and that in the future news relative to expectations is likely to have more of a bullish effect than a bearish one. Innovation and enterprise are likely to bring the same kind of 1.5 million percent-a-century returns that the market achieved in the 20^th century, as documented by three London Business School professors in Triumph of the Optimists, a splendid work of comparative market research we have repeatedly lauded. We outlined our views in detail in our book, Practical Speculation, which hit the bookstores in March circa S&P 800, and concluded: “In five years, maybe two or three, the Nasdaq below 1000 and the Dow below 7500 will be bad memories. Those who doubted the fruits of investing and enterprise will have faded into well-deserved obscurity.”

With such tidal forces favoring the bulls, we are reluctant to short stocks. It becomes too difficult to find the right time to sell and then to buy them back, at least for us. We’ve missed too many gigantic bullish moves in the past to try to fine-tune the ripples.

Today, we classify the reasons for bearishness in order to provide a history and a Baedeker of the ideas that have had the market in their grip for the past few years. Retrospectively, many of those ideas were good—better than ours. As to whether they will be good in the future, you be the judge. We have been wrong on many occasions in the past, and hopefully we will live to be wrong on many occasions in the future. At least we have classified them, a la Linnaeus, so that others can identify related species and fill in the gaps.

Bearish Cornerstones

Since ancient times, it has been customary to place in foundations a cornerstone inscribed with the history of the king responsible for the building. Without in any way demeaning the contributions of such eminent prophets of doom as Tice, Prechter, Fleckenstein and Grant, we believe we may say without fear of contradiction that the king of the bears is Alan Abelson, the lead columnist of Barron’s. Not only is Abelson the most famous, witty and prolific of the pessimists, but his record of bearishness is the longest—indeed, it goes back to antiquity, as he started the column in 1966, with the Dow below 1,000—and it has been continuous. His cornerstones have been laid weekly, and are now so numerous that we are able to assemble a reasonably complete catalog of reasons for pessimism.

Our book includes a full enumeration of Abelson’s bearish arguments from 1990 through 1999, and as we note there, the columnist’s accuracy in 2000-2002 was better than our own—so good, in fact, that one might think that even a Grandmaster of Grump would be satisfied. But the 80% drop in the Nasdaq and the halving of the S&P 500 left him more bearish than ever. We should have known better. After all, in October 1997, after the worst point drop in the Dow ever prompted the closing of U.S. markets, he wrote: “What do you call a 550-point drop in a single day? A start.”

Abelson had not returned our telephone calls by the time we went to press on Tuesday. When we interviewed him in the summer of 2001, he told us some people feel he has been bearish all his life—and with one or two minor exceptions during the 10 years we studied, during a period when the Dow went from 2750 to 11,500, we can confirm the truth of that assessment. Here is a compendium of his latest reasons for bearishness.

Alan Abelson’s

Reasons for bearishness, 2003

Reason	Dates	Representative quote
Post-bubble blues	12/30; 2/3; 2/24; 3/31	“Pure and simple, we’re still suffering the consequences of that once-in-a-generation mania that encompassed Corporate Wall Street and Main Street, lock, stock (especially stock) and barrel. It was the granddaddy of all speculations, and it left a large and deep footprint that only time can efface.” (2/3; DJIA 8109)
Embers of hope	1/6; 2/3	“The embers of hope still smolder and tend to flare up. And until they’re completely extinguished, the bear market won’t repair for any prolonged hibernation.” (2/3; DJIA 8109)
Main Street distrust of Wall Street	2/3	“[T]he public’s doubt and suspicion are now firmly planted, won’t easily be exorcised, and are due to haunt every stock market rally.” (2/3; DJIA 8109)
Economy in soup	1/27; 2/24; 3/3; 3/24; 4/17	“In some ways, it would be a relief if we did what we obviously intend to do – invade Iraq and get rid of Hussein. If nothing else, the stock market would stop getting jerked around so horribly every minute of just about every session. Then at least, the poor thing could concentrate on the real reasons for it to go down. Like Manpower’s very gloomy survey of the outlook for jobs or the truly dismal confidence soundings by the Conference Board, the sorriest in nine years. Reasons, alas, of which there’s no shortage.” (3/3; 7891)
Investors fail to realize economy in soup	2/24	“The economy, in short, is still in the soup and shows no real inclination to emerge any time soon, certainly not this year. Which is something investors haven’t quite reconciled themselves to and helps explain why stocks, even after their horrendous declines, are selling at multiples more often seen near bull market tops than bear market bottoms.” (2/24; 8018)
Good Old Days gone forever	3/17	“The only true golden eras for stocks in the past 80 years were the ‘Fifties and ‘Sixties, which began when equities were very cheap (the S&P at seven times trailing earnings) and bonds very rich (Treasuries pegged at 2%).” 3/17; DJIA 7859)
Low levels of cash in mutual funds	1/27	(Quoting Merrill Lynch’s chief investment strategist) : “’Institutional and retail fund managers’ cash levels are the lowest we have ever recorded.’… if you look back at Merrill’s surveys of the past couple of years, one of the vital ingredients for a rally in stock prices was that the funds sported an abundance of the long green.” (1/27; DJIA 8131)
Overvaluation	1/27; 2/24	“No matter how you define it – P/Es, price times book value (sic), dividend yields—cheap emphatically isn’t what stocks are today.” (1/27; DJIA 8131)
War in Iraq	1/27; 3/3	“The economy is already too enfeebled to absorb the stunning shock of war, accompanied by a spike in crude prices and a sharp jolt to quivering consumer confidence, and absent a strong recovery in the economy, there’s just no way stock prices can go higher.” (1/27; DJIA 8131)
Dividend tax cut	1/13	Citing Morgan Stanley’s Stephen Roach: “Both the Fed and the fiscal authorities seem more than willing to embrace stock-market targeting…[but this is the] recipe that got America in trouble in the first place—hyping the stock market and the bubble-induced excesses it prompted in the real economy.” (1/13; DJIA 8784)
Not enough government stimulus	1/13	“[A]t the moment, when it comes to stimulus, more is better.” 1/13; DJIA 8784)
Coming collapse of housing bubble	4/21	“[W]hat these intimations of a turn in housing suggest is that the consumer may be forced to cave, and there most assuredly goes the economy.” (4/21; DJIA 8337)
Stock rally reflects animal spirits, not the discounting of an economic revival	5/5	“For all we love the market … our conviction remains that the blessed thing is not so much discounting a revival of the economy as it is reflecting a return of animal spirits. Which means you better enjoy the rally while it lasts.” (5/5; DJIA 8582)

Even after all these years, we cannot help being amazed at Abelson’s zeal. If every last ember of hope must vanish before the next bull market can start, we may be in for a long wait.

The Spec Duo confesses

But we’d like to make a confession. We don’t care whether we’re in a bull market or a bear market. We find the intricacies of definition arcane and essentially useless. What we care about are statistical expectations of returns in reasonably tradable future time periods. That is why we have been closely following the relation between prices, earnings and interest rates lately. This relation is embodied in the so-called Fed model, a rough method used by Fed economists and others for determining whether stocks are undervalued or overvalued.

The actual equation is simple: divide the projected annual earnings of the S&P 500 by the yield of the benchmark 10-year Treasury note to arrive at a fair value for the market.

What you’re really doing is comparing the earnings yield of stocks to the “risk-free” return on Treasuries. If the earnings yield is close to or higher than the 10-year government note yield, the stock market is undervalued by a comparable proportion. If the earnings yield is considerably lower than the note yield (like by more than 1%), then the market is overvalued.

We did the calculation ourselves this week, using data from 1962 through 2002. We used only earnings estimates actually available at the time of forecast. We found that the S&P 500’s fair value was 1415 at the end of last year. With the actual index at 879, the market was 61% undervalued.

Based on what happened over the last 40 years, we would expect a 15% return for the S&P 500 this year.

New bullish foundation

While we are by no means totally enthralled with the Fed model, we feel that interest rates at these low levels provide a highly bullish backdrop for stocks. Our own tests using actual forecasts and normal rules of thumb as to what’s going to happen when people making a negative 1% return after inflation in money-market funds seek alternative investments of a riskier nature confirms the bullishness of our expectations and supply-demand argument. The Fed valuation model is a good start, and we would not want to be against it when it’s 40% under- or over-valued—especially when our tests, which we’ll report next week, show that following it at the extremes would yield good profits.

Moreover, we are seeing other new props for the bullish case:

Many people with fixed system have made fortunes by following the bearish trend during recent years. They’ll all have to go long in waves in 2003, as even the most long-term trends turn bullish.

The mere mention of optimism these days is enough to drive some people over the edge. In response to our last column, in which we humorously described some guaranteed aspects of the bearish case, we received a death threat mixed among the more usual traditional bearish messages such as “You know damn well that this market is going to Dow 1000 and you should be ashamed for your role in keeping all these suckers in for the ride.” On the other side of the coin, our editor, Jon Markman, wrote a column providing a forum for the bearish views of Didier Sornette, who sees a great likelihood of a devastating earthquake in the market; Jon received 100 times the normal number of favorable responses.

Bears seem to be reaching for straws. Take the latest argument from the pessimistic Richard Russell: No longer is it the trend or the valuation—now it’s the ease with which his wife is able to get reservations at fancy restaurants in Manhattan, and the prevalence of get-rich schemes hitting his e-mail box. For Alan Abelson, it’s no longer that sentiment is overwhelmingly bullish. No, there’s too much concern about corporate greed and misleading statements and the sluggish economy for that. But now, he opines that the market won’t be ready to go up until not one bull is left.

Thus, for psychological, economic, value and technical reasons, we are bullish for the long term. As to whether this is worth anything, we have our doubts ourselves. But at least we have presented the framework within which we tried to perform an unbiased scientific classification of the bearish categories. In a year or two or three, the arguments of Abelson and fellow bears for a continued decline in stocks may look prescient. At the moment, those arguments look to us like braces supporting a house destined to tumble down the hill.