Market Advice - Be Careful What You Believe!

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
February 27, 2007

Market Advice – Be Careful What You Believe!

IN THIS ISSUE:

1.  Conflicting Views Of The Stock Market Abound

2.  Why The Stock Markets Should Go Down

3.  Why The Stock Markets Should Go Up

4.  Why Both Bulls & Bears Could Be Wrong

5.  Always Consider The Source & Conflicts

6.  The Value Of Independent Analysis

Introduction

Back in January, I read two articles on an Internet website that discussed what financial analysts expect for stock market prices in 2007.  One was entitled “Why Stocks Will Fall” and the other was entitled “Why Stocks Won’t Fall.”  The obvious aim of the website was to show that there is not necessarily any consensus about what the market may do in the coming year.

Each author made good, well-reasoned arguments as to why their viewpoints were correct, but obviously one of them has to be wrong.  Well, I guess that’s not exactly right – the market could go up half of the year and down the other half, and then both could claim to be right.  Or the market could go sideways and both would be wrong.

The point I wish to make this week is that you can find support for virtually any kind of economic or market prediction you can imagine.  You can find convincing support for almost any scenario, as you probably already know, especially as it pertains to the stock markets.  But as you review the various conflicting market viewpoints, it is important to be able to discern if their reasoning is sound, or if it is loaded with a hidden agenda.

In this week’s E-Letter, I thought it might be interesting to review the thinking behind the two articles noted above, as well as others I have read over the past month or so, and then compare that with what my most reliable sources are saying.  I’m also going to discuss why you should definitely consider the source, reasoning and potential conflicts behind any market predictions you read.  The money you save may be your own.

Conflicting Opinions Abound

As I’m sure all of you know, stock market predictions are not hard to come by.  With the Internet and 24-hour financial news networks, information is everywhere.  However, much of this information is just plain wrong or misleading, in my opinion.  Many of today’s market analysts feel they need to have their fingers on a wide range of potential market factors, ranging from the usual corporate fundamental analysis to global events and other outlying factors that could come into play.  Trying to interpret the possible outcome of any of these factors, especially when looking at a combination of all such factors, leaves a lot of room for error.

I’m not saying that all of the sources of these various opinions are intentionally trying to mislead the public (although, as I will discuss below, some sources may not be above trying this).  Instead, I’m saying that the economy and stock markets are huge, with many traditional and non-traditional factors affecting them day in and day out, and even with the best possible analysis, the free markets sometimes defy even the best attempts to predict their behavior (trends).

In addition, the Information Age has also ushered in what I call the “Guru Era,” where those who successfully predict the direction of the market are suddenly treated like rock stars, with book deals, public speeches, and now even TV appearances.  Some have even been asked to give testimony before Congress regarding stock and bond market issues. 

Unfortunately, some retain their Guru status even if their last correct forecast or market call was a long time ago.  The same often holds true for professional money managers.  A money manager that had a hot spell of performance in the past, but failed to do well in recent years, may still be actively promoting himself or herself based only on that prior hot period.  Never mind that they may have missed all or most of the greatest stock bull market in history over the last 20+ years.

With the potential rewards for being crowned a Guru so high in today’s world, it’s no wonder that so many “wannabes” throw out predictions of all shapes and types, just to be different.  I would even argue that some market analysts make predictions that are opposite to the prevailing consensus of most economists and market analysts, just in case the market takes an unexpected turn up or down, allowing them to claim success.  If they happen to get lucky and be correct, they get to be the latest Guru.

However, just because the market goes in the direction predicted by a particular analyst doesn’t mean it did so for the reasons cited by that analyst.  Unfortunately, many investors do not dig deep to see whether the conditions noted in the analyst’s predictions were those that led to the success of his or her forecasts or investment model.  They are blinded by a large return and a gloating analyst saying, “I told you so.”

With these analyst caveats noted, at the end of the day, almost all students of the market, so-called Gurus included, have to venture an opinion on whether the markets are going up or down.  Let me briefly review a sampling of the current arguments for the US stock market this year.

The Arguments For A Down Market

What follows is a brief discussion of the major issues that might lead to a stock market downturn in 2007.  As always, there are plenty of reasons why the equity markets could go down this year (or any year).  The following risks are in no particular order, and are obviously not an exhaustive list of potential problems that the stock market may encounter during the year:

  1. Risk of Recession – Some analysts say the economy is slowing down, and may slide into a recession.  They point to the inverted yield curve, which has often been the harbinger of a recession.  If correct, this would mean that the 2007 earnings estimates for US companies are far too high, and stock prices could suffer.

  2. Investor Complacency – In his infamous “irrational exuberance” speech in December of 1996, Fed Chairman Alan Greenspan warned that asset prices were overvalued, that investors had become overconfident, and widespread speculation was driving equity prices to “bubble” levels.  As it turned out, equity prices continued to soar to all-time record highs for the next three years.  Today, some analysts suggest that equity prices are once again at bubble levels, and that the bubble is sure to break any day now, what with the so-called “risk premium” narrowing once again.

    A narrowing risk premium simply means that illiquid small company stocks, usually a speculative investment, are now being given valuations similar to larger, higher quality equities.  The big question is when this resurgence of “irrational exuberance” will come home to roost.  Will it be in 2007, or over three years from now?

  3. Stock Market Correction Is Overdue – This reasoning is really a function of the market’s historical tendency to experience a downward correction after periods of strong advances.  One report I read indicated that the current upward trend without a 10% correction is the second longest since 1900.  While a 5% to 10% correction would be a short-term negative event for the markets, many analysts say that such a correction would be healthy for the markets in that it would eliminate some of the excess speculation and provide a solid base for a continued upward trend.  Such corrections tend to correct the investor complacency discussed in item #2 above by restoring risk premiums to more normal levels.

  4. Market Uncertainty – The old saying goes that the “market hates uncertainty.”  There’s certainly no shortage of uncertainty today, with terrorism, signs of a softening housing market, Asian competition, nuclear proliferation, volatile crude oil and gasoline prices, etc., etc.  Just pick one and you can easily build a bearish scenario for the stock markets.

  5. Weakness In Commodities Prices – One bearish report I read referred to the broad decline in commodities being a statement of the US economy’s health (or lack thereof).  Another analyst noted a saying that “the US economy has a copper roof,” referring to the historical tendency for the price of copper to be a good leading indicator of economic growth.  Copper prices collapsed during 2006, as well as prices of many other commodities.

I could go on and on with various reasons why the US equity markets should go down in 2007, and perhaps even in 2008 and beyond.  But most all of these reasons have been out there for some time now, and yet the Dow has continued to make new all-time high after new all-time high.  Maybe there are reasons for this.

Why The Market May Continue To Defy Gravity

The case to be made for continued gains in the stock markets in 2007 is also very compelling.  What’s more, I find that the bullish sentiment tends to be based more on fundamental factors such as yield spreads and corporate profits rather than the external influences being put forth by the bears.

In fact, some of the bullish arguments attempt only to refute the interpretation of certain market factors by bearish analysts, rather than make their own case.  This head-to-head confrontation always makes for interesting economic reading, but we are still left with not knowing which camp will be eventually proven right.  In any event, here are some of the leading arguments for stock market gains in 2007:

  1. Relatively Small Yield Spreads – In response to those who point to the inverted yield curve as a sure sign of recession and lower stock prices, some analysts point to the fact that the spread between the yield on Treasuries and corporate debt is relatively small, an indication that bond traders are comfortable with the health of US companies, and thus the economy.  Assuming this is correct, corporations should continue to increase profits and command higher stock prices.

  2. Strong Corporate Earnings Outlook – One of the most-watched statistics in stock market investing is the Price/Earnings (P/E) Ratio.  The higher the P/E Ratio, the more expensive a stock is deemed to be.  Bullish analysts point out that the projected P/E multiple for 2007 is 18.3 for the 3,000 largest US companies making up the Russell 3000 Index.  Plus, Thompson First Call (an earnings estimate service) expects corporate earnings to be strong enough to push this multiple down to 15.9 in 2008.

    Analysts who point to earnings do not ignore the potential problems that exist in the marketplace (as discussed above), but rather say that it’s a sign of the strength of US companies to continue to post favorable earnings in the face of these negative factors.  It’s hard to argue that things could get much worse in 2007 than they were in 2006, so these analysts continue to believe that corporate profits (and thus stock prices) should remain strong.

  3. Global Demand For US Assets – Many sources indicate that global liquidity is very plentiful, with much of that money seeking a stable investment environment.  At present, the US markets represent such a stable investment alternative.  While some US stock market analysts worry about continued foreign investment, it appears that global investors do not necessarily share that concern.

  4. Reduced Supply of Stocks – Stock buybacks by corporations and private equity transactions have somewhat reduced the supply of stocks available to investors, mutual fund managers, etc.  Obviously, this is a positive development for stock prices, especially in light of continued strong demand for US equities, but it is only one factor, and corporations have certainly implemented stock buyback programs at the wrong times in the past.

  5. The Fed’s “Soft Landing” – A survey by the Russell Investment Group in late 2006 and published in the Wall Street Journal indicated that 86% of money managers surveyed expected stocks to rise in 2007, while only 12% expected the market to fall.  Russell concluded that the growing conviction that the Fed had achieved a soft landing for the US economy was the basis of most of the managers’ expectations.

    Under this scenario, it is believed that the Fed will not increase interest rates in the future as growth and inflation are both under control.  Of course, if the Fed does not raise interest rates in 2007, this will definitely be another bullish factor for the stock markets.

    A separate report discussed in the same article goes on to say that even formerly bearish analysts are now jumping on the bull’s bandwagon, which seems to be true to some extent.  As the bears are converted to the bull’s case, this could drive US equity prices even higher.  Yet it is important to note that when the bears get converted and join the party, the end may not be far away.

  6. Misreading Commodity Price Corrections – Bullish analysts discount the correlation between the recent fall in commodities prices and the health of the US economy.  Analysts of most all shapes agree there is a correlation between commodity prices and the economy, as do I.  However, some bullish analysts suggest that the recent downward correction in the price of copper (and other commodities) was from an artificial high driven by rampant speculation in 2006.  Indeed, if you look at a chart of copper prices (see below), the current price appears to be pretty much in line with the upward trend that was evident prior to the speculative excesses.
     Historical Copper Price Chart
    Thus, the bulls contend that their bearish counterparts are taking the recent correction in commodities prices out of context in relation to prices before 2006.  Having been in the commodities business for many years and looking at the charts, I have to side with the bulls on this one.

Both The Bulls & Bears Could Be Wrong

As is the case in most arguments, there is a middle ground.  Some of the articles and reports I reviewed discussed the case for a sideways market in 2007, caused by the interaction of both good and bad market influences discussed above.  However, you don’t hear much about sideways markets in the financial media.  You can attract investors’ attention when you talk about bull or bear markets, but a “nowhere” market gets no one’s attention.

When discussing a sideways market, it’s important to realize that these analysts are not talking about a benign sideways line on the graph, but rather a very volatile ride, much like a roller coaster where you experience dramatic inclines and declines, only to end the ride at the same place you started.

We’ve already seen some evidence of this type of market volatility in 2006.  As the Fed prepared to stop raising interest rates, every hint of economic news seemed to move the markets.  For example, if the unemployment rate was up, it meant the Fed would not raise rates any more, but if it was down, just the opposite might be true.  If the GDP or inflation numbers came in too high, the markets would have a negative knee-jerk reaction out of fear the Fed would raise rates.  While 2006 ended up with double-digit stock market gains, it wasn’t a gentle ride by any means.

Another potential indicator of sideways markets comes in the form of a graph produced by Rydex Funds.  This graph shows the historical price of the Dow Jones Industrial Average (DJIA) over the 100 years ending 2005. You can view a copy of this graph by clicking here.

As you can see, the DJIA has experienced a number of market cycles consisting of bull market periods followed by bear market phases and sideways markets.  Based on historical cycles reflected in this graph, we could enter into a sideways market phase sometime in the next couple of years that could last for another decade or so.

Of course, one of the problems in projecting an outcome based on historical market phases is that it’s hard to tell exactly where you are in the current phase.  Bulls argue that we’re in a temporary sideways portion of an otherwise continuing bull market.  Bears, on the other hand, argue that we’re at a plateau and the next major move will be downward.  Looking back at the historical cycles, you realize that it’s easy to make a case for bull, bear or sideways markets in the future.

But in the meantime, the US equity markets just continue to rise to new all-time highs.  And too many investors are largely on the sidelines, and have been since the bear market of 2000-2002.  They are hoping a downward correction will unfold to give them a comfortable place to get back in.  FYI, bull markets are typically not so accommodating.

This is one of the compelling reasons I directed my business toward finding professional money managers with successful strategies for dealing with all types of market environments – up, down or sideways – well over a decade ago.  This is the very reason you should consider the actively managed investment programs we offer, but I am getting ahead of myself.

Always Consider The Source

When it comes to information about the economy, the markets or specific investment advice, it is always critically important to consider the source.  Specifically, you need to know if the source of the information you are receiving is independent, or if the information is biased in some way in an effort to steer you toward their particular products and/or services.  Likewise, you need to determine if the information or advice is credible.

In my 30 years of investment experience, I have found that many (if not most) of the sources of economic, market and investment advice are not independent, or are not credible.  Many of the sources noted in this article are biased – for one reason or another – toward a particular view of the economy or the markets. 

I have recently written about what I call the “perma-bulls” and the “perma-bears.”  The perma-bulls are those that are always bullish on the US stock market.  Perma-bulls can be found in all forms of communication – newspapers, magazines, newsletters, TV, brokers, the Internet, etc.  Perma-bears, who are always bearish on the economy and the markets, can likewise be found in all of these same places.

The key is to understand that most of these polarized groups and sources usually have a product or service that they are selling that caters to a particular view of the economy and/or the markets.  The product or service, in most cases, is designed to work only in the particular economic or market outlook espoused by the source.  It is therefore not independent.

And then there is the Internet where you can find any view, any opinion imaginable on the economy, the markets and investments.  Anyone can put up a website; anyone can claim to be an expert; and anyone can offer opinions and advice.  On the Internet, there is no accountability.  So beware of anything you might read on the Internet.  (And yes, I realize that you are reading this E-Letter on the Internet.  You should subject my E-Letters to the same level of scrutiny as any other online source of information.)

The point is, you need to carefully consider the sources of information you rely on to make investment decisions. 

The Value Of Independent Analysis

As an investment writer, and a manager of managers, I review a great deal of information on the economy, the markets and investments in general.  Over the years, I have subscribed to dozens of research publications, newsletters and other related services.  I use these various sources to form my own opinions about economic and market trends.  Sometimes I am right, and sometimes I am wrong – as is true with all students of the markets.

As noted above, the most important factor to consider when reviewing economic and market projections is whether the source of the information is independent of vendors of investment products.  That’s because an organization that is truly independent must rely on accuracy to be able to continue to sell subscriptions for their information products.  As you might imagine, a research firm that continually issues incorrect forecasts won’t last very long.

As regular readers will note, I depend a great deal on the advice and analysis from The Bank Credit Analyst (www.bankcreditanalyst.com).  A client introduced me to BCA back in 1977, and I have been a continuous subscriber ever since, going on 30 years now.  I consider BCA to be one of the best (if not the best) independent sources for economic and financial information around.  That’s why I pay their significant subscription fee every year.

Having subscribed to BCA for almost 30 years, and seeing their accuracy for three decades, it should come as no surprise to regular readers that my views on the economy and the major investment markets tend to parallel those of BCA.  Thus, amid the various arguments I have outlined above, let me provide you with the benefit of BCA’s latest thinking about the economy and stock markets.

As I have noted in recent months, BCA predicted the latest slowdown in the economy, but emphasized that a recession was not the most likely scenario.  Likewise, BCA suggested the economy would rebound in 2007.  The stronger than expected GDP report for the 4Q (up 3.5% annual rate) seems to have proved BCA’s point even earlier than the editors expected.

As with its recent economic forecasts, BCA has also been accurate in its outlook for equity prices.  BCA has argued for the last several years that equity prices would likely surprise on the upside, and they have.  Likewise, BCA has predicted that interest rates would remain relatively low and move in mostly narrow trading ranges.

The bottom line is that BCA expects equity markets to move higher in 2007, barring any big surprises such as a terrorist attack or unexpected Fed tightening.  Bond prices, on the other hand, should stay in a trading range reflecting the continued narrow interest rate spreads.

It is also important to note that, while BCA expects equity prices to move higher, it will likely not be without significant volatility, which seems to have become the hallmark of the equity markets in recent years.  This expected volatility could give buy-and-hold equity investors quite a roller coaster ride during the year.  Some active managers, however, should welcome this volatility as it could give them opportunities for their trading systems to exploit shorter-term trends, though there is no guarantee that they will be successful in doing so.

Conclusions

In this week’s E-Letter, I hope that I have driven home the idea that it’s possible to support virtually any bias you want to have toward the stock market.  Those whose bias relates to selling products that appeal to fear will always find factors that support that point of view, while those who want to appeal to greed and sell more mainstream investments will find support for their bullish scenarios.

I don’t buy into a perma-bull or perma-bear outlook, because common sense tells us that markets don’t always go up or always go down, but rather move in cyclical ups and downs as the 100-Year Dow Chart illustrates.  That’s why I have always sought out investment strategies that have the flexibility to deal with both bull and bear markets so that the risks of being in the market could be managed.  I invested in such strategies long before I ever began making them available to my clients.

While many stock market analysts, including BCA, expect stock prices to rise in 2007, the market is not without risks.  Therefore, I think it’s wise to have at least part of your portfolio invested in actively managed strategies where a professional money manager has his or her fingers on the pulse of the market, and can move to cash (or even short in some cases) if market conditions change.   

If this common-sense approach to investing sounds reasonable to you, then I suggest you check out the actively managed investment programs offered by Halbert Wealth Management.  Just give us a call at 800-348-3601, drop us an e-mail at info@halbertwealth.com or visit our website at www.halbertwealth.com.

Very best regards,

Gary D. Halbert

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Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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