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Cult of the Bear, Part 1

While doing all this war-gaming, one scenario kept coming up repeatedly: The slow-motion slowdown. It starts with the consumer, who after years of spending, finally tires. Soon, it infects corporate revenue and profits. Slowly, it cascades its way across different sectors: housing, durable goods, discretionary spending, entertainment. Eventually, the decay spooks the markets.

The Crowd Is Bullish

There is a lot of anecdotal chatter about sentiment , but I prefer to stick with quantitative data. I hear too many people say, "All my colleagues/friends/brother-in-laws are (fill in the blank)." That's meaningless.

The Business Week survey reveals one group of bullishness. When I made my guess, I never figured I would be the outlier to the downside. Silly me.

One alternative to conjuring up various scenarios would be to simply extrapolate this year into next. I suspect that's why so many forecasters cluster around the same numbers. Most of the surveyed group is clustered between 11,000 and 2,000 (about plus 5%-10%) on the Dow, while advising a 40% to 75% U.S. equity exposure.

But its not just the Pros: Other surveys reveal a similar bullishness. A WSJ.com poll of more than 5,000 people taken on Dec. 30 shows 46% expect the same thing in 2006 as the market gurus: between Dow 11,000-12,000. Another 12% think we end up at more that 12,000. About 22% expect to end 2006 unchanged. Only 9% expect we will see the Dow between 10,000 and 10,500 -- a mild correction of less than 10%. Just 11% believe the Dow will drop below 10,000.

This means 89% of these WSJ readers do not believe 2006 will be a substantially down year.

Note that the crowd isn't extremely bullish, however. It will take one more rally toward 11,000 to get investors to breathlessly embrace the market. Then the trap door gets sprung.

I understand why the crowd is so bullish. The past few years have seen terrific data points: S&P 500 earnings have grown by double digits for 14 consecutive quarters. Companies are awash in cash; they have been buying back shares at the most rapid rate we've seen since the late 1990s; more than $456 billion worth in 2005, according to TrimTabs Investment Research. Since the dividend tax rate was slashed to 15%, the number of companies issuing dividends has increased, and pre-existing yield-payers have upped their dividends significantly. That's before we get to the record-setting M&A activity last year.

Despite all of these elements, the markets are essentially unchanged. Look at any U.S. index for the past one or two-year period -- or even four or five -- and there's been very little progress made. Except for the pre-Iraq war selloff and subsequent snapback, and the rally from the October 2005 lows, there hasn't been much of a market gain. Aren't you curious as to why that is?

Source: TheMessThatGreenspanMade

I'd be a lot more bullish about prospects for U.S. equities if companies were plowing that half a trillion dollars back into R&D, hiring and spending. Instead, I am bewildered at the dearth of innovation in much of America's corporate suites. (Thank goodness for Google (GOOG) and Apple (AAPL)!)

Reality vs. Headlines

I've discussed this repeatedly: The economic data are actually far more discouraging than the headlines would have you believe:

  • Unemployment has fallen to 5% primarily due to labor pool dropouts (3.5 million at the peak; now 2.3 million) -- and not a surge of people getting jobs, as detailed here;
  • Private sector job growth has been 0.8% since the recession ended. At this point in prior recoveries, job growth averaged about 8.8% -- and has never been less than 6.0% before, according to the Economic Policy Institute.
  • Inflation appears more benign than it actually is. Putting aside the foolishness of the "core" rate, the key reason is Owners Equivalent Rent. If housing were appropriately calculated, then CPI would be closer to 5.3%, as detailed here.
  • GDP and consumer spending have been propped up by mortgage equity withdrawal (MEW); Typically, MEW accounts for 0.25 to 0.50 GDP points. Over the past four years, the MEW accounted for about 90% of GDP -- between 2.5 and 3.5%, according to the blog Calculated Risk Without MEW, GDP isn't 4.3% -- it's less than 1%.
  • Big Old Jet Airliner

    Imagine the markets as a four-engine jet. Let's name the four engines M&A, buybacks, dividends and earnings growth.

    Our jet is cruising along at ... oh, let's say 10,847 feet. All four engines are at full throttle. Yet for some reason, the plane cannot seem to make any altitude. Every time it gets near 11,000 feet, it seems to stall. Once or twice, it even swoops down to gain some speed but still cannot seem to break that altitude.

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