Only in America

By Bob Wood

Watch now, here comes another “bearish” article from the guy who seems unaware that domestic stock markets have reached new, all-time highs, despite his exhortations of why that should not be happening! I know, it looks bad, doesn’t it?

And it would be bad without my equally enthusiastic calls for investing heavily in foreign markets and also in commodities that have fared far better than those ever-climbing Dow and S&P 500 shares. So as wrong as I have been on domestic markets, I have been even more right about international markets, which are also rising to new highs.

Actually, those international markets have reached new, all-time highs, while the S&P 500 still has some climbing to do. From my perspective, the Nasdaq may never again reach its previous high of over 5,000. And after factoring in inflation, domestic investors remain deeply in the red. Since the purchasing power of the dollar has fallen about 30% this decade, the S&P 500 needs to reach 2,000, just for investors to break even in real terms.

Investors in commodities like energy and gold have fared better during the same time, as have those investing in Brazil or India. Over the past five years, the basket of gold stocks represented by the gold stock index, HUI, has risen about three times faster than the seemingly strong S&P 500. The Brazilian stock market has risen about five times faster, and the Indian stock market has done even better.

So even if you had followed my “perfect portfolio” recommendation in the summer of 2003 and loaded up on the long side with international and emerging market stocks or mutual funds, offset with a short position in the domestic markets, you would have done well. My model portfolio account has been invested using this style, and it has done far better than domestic averages during the past five years.

I offer this information only to set the stage for — more bearishness! You see, I’m not the only one who thinks this way. Another portfolio manager, John Hussman, PhD, who manages the Hussman Strategic Growth Fund, offered more supporting data this past week.

Yes, I know you may be skeptical about Hussman if you have checked his performance for last year. But disregard his one bad year in this decade and read his most recent weekly message. He shows the impact of a negative return on your investment portfolio in any given year. This one-year loss, assumed as a 20% drop, relates to the potential downside risk taken by most stock market investors who assume full market risk, hoping to cash in during the big up-years occurring during bull cycles. Hussman shows how previous gains can be wiped out by just one bad year.

You can find Hussman’s complete message, ‘’Baron Rothschild Game,’’ on his web site, www.hussmanfunds.com. But here is his basic premise:

‘’Suppose that the dealer lays cards down, one after another. Each is an annual market return. At any time, you can call out “Baron Rothschild” and go to a defensive position, or you can gamble and get the entire market return the dealer shows next. The gain cards read, say, 15%, 20%, 25% and 30%. If you’re defensive, you lag the market by 10% when the market return is a gain, but you get, say, 5% if the market return is a loss.

There is one -20% loss card. Once it appears, the game ends and everyone counts their dough, compounded.

It turns out that if the loss comes anytime before the 5th card, you’re almost always ensured to beat or tie the dealer by immediately blurting out “Baron Rothschild” even before the first card is shown. For example,

20%, 20%, 20%, 5% beats 30%, 30%, 30%, -20%.

15%, 15%, 15%, 5% beats 25%, 25%, 25%, -20%.

20%, 10%, 5%, 5% beats 30%, 20%, 15%, -20%.

5%, 5%, 5%, 5% ties 15%, 15%, 15%, -20%.

You can easily prove to yourself that even for a six-year market cycle, you still generally win even if you call out “Baron Rothschild” after year two. It just doesn’t pay to risk the big loss.

The point of this isn’t that investors should always take a defensive stance – some market conditions are associated with very strong return/risk profiles that warrant substantial exposure to market fluctuations. The point is that the avoidance of significant losses is generally worth accepting even long periods of defensiveness.

Because of the mathematics of compounding, large losses have a disproportionate effect on cumulative returns. Remember that historically, most bear markets have not averaged 20%, but approach 30% or more. A 30% loss takes an 80% gain and turns it into a 26% gain. It’s difficult to recover from such losses, which is why the recent bull market has not even put the market ahead of Treasury bills since 2000 or even 1998. So again, the point is that the avoidance of significant losses is typically worthwhile even if, like Baron Rothschild, one is defensive “too soon.”

So Hussman shows exactly what many investors endured during the bear market cycle during 2000 – 2002. He argues for taking much less risk in your portfolio after achieving solid returns over a multi-year period, as you may have enjoyed while the domestic stock market climbed from early 2003 to today.

Of course, the basic fundamentals should always be your guide. History clearly shows that some times have proven better than others for stock market investors. Secular bull markets typically begin when valuations are low and interest rates are high. Bull markets end when valuations are high and rates are low, as we see now.

Sure, many people in the financial media and at the big brokers remain bullish, regardless of changes in the underlying fundamentals, which we, again, see now. Only in America can they call massive job losses at our last remaining auto makers “a good thing,” since, in the long run, that action will help restore the companies’ profitability. What job losses do to the prevailing wage base is ignored.

Only in the U.S. can we see another vital industry, home building, fall so dramatically while we still hear Bulls calling this nothing worrisome, since those weak sales figures surely mean that droves of buyers will soon enter the housing market in search of bargains. The fact that this country now has over 2 million vacant homes seems meaningless to them.

Note: I didn’t say “unsold homes,” since these are the vacant ones. Add to that number the inventory of homes still occupied but also available for sale. Comparing this to the projected number of 1.6 million home sales for 2007, I see cause for worry about the eventual impact. And then, for added color, include in this picture more than $1 trillion in adjustable rate mortgages due to reset to higher interest rates this year.

And only in America can we see an annual trade deficit of nearly $800 billion and still call it another sign of a strong economy! How does the need to borrow another $2 billion each day to pay for such reckless spending show strength?

Of course, a massive, structural demographic shift is also occurring in the U.S. The first phase of the baby boomers is now looking forward to imminent retirement. Using real accounting measures puts the Federal budget deficit for 2006 at about $4.5 trillion. That’s the number we get when factoring in the assumed liabilities for increasing Social Security and Medicare costs, which were not set aside in 2006 to pay for them.

But rather than reserving that money, as any saver for retirement costs must, the Federal government led by the Bush Administration, took surplus contributions made by workers as normal operating income — and spent it all! And this is no surprise, since all previous administrations have done the same.

“No problem,” they tell us, since they are not obligated to pay these promised benefits and can change the laws at any time. And don’t we see that happening now, with means-testing for Medicare premiums already being instituted?

So with all these issues clouding our economy and promising severe storms in the near future, what is the outlook for retirees, the fastest growing segment of our population? Add to this the effects of our losing two very costly wars and competition from China for energy resources. And have you heard how much time Chinese leaders are spending with the leaders of Saudi Arabia?

I think you get the idea! My bearish call on domestic markets will remain in place for as long into the future as I can see. Perhaps domestic markets will rise higher without me. But my bullish calls for international markets and commodities like energy, gold, silver and food stuffs also remain in place — for just about as long. Just because I’m steadfastly bearish on domestic markets doesn’t mean bull markets fail to exist elsewhere.

They do exist and always will. But getting stuck in our home markets, now selling at premium prices across the board, means increasing the potential for Hussman’s ‘’Baron Rothschild Card.’’ Sure, I may look wrong on domestic stock markets, but having been right about much stronger markets around the world has helped immensely. If you are riding the domestic markets to their new highs, check again at the fundamental picture to see if your ‘’Goldilocks’’ is still saying “just right”!

Have a great week,
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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