1-22-2010

Is The Bull Market Over Already?

Could the bull market be over already? We haven’t even had a year of up-market yet. We have not gotten back to the old highs. Most investors have not fully repaired their net worth. Pundits are worried about bubbles, double dips and debt burdens. The stock market has had a three day correction. To date, most corrections in this bull market have been small. The questions people are wondering are: Have we now started a big correction, or have we ended the bull market already?

Bubbles, as explained in The Economist, are characterized by high asset valuation as well as “rapid growth in private sector credit and an outbreak of public enthusiasm for particular assets.”[i] The most worrisome bubble currently being bantered about is the economic growth rate in China. Jim Chanos has opined on this and it has quickly been popularized in the financial press. Others who have been long-time China bulls dispute this. Jim Rogers disagrees with the Chanos assessment, but Jim Rogers has come off of a bad year in his agricultural investment strategy, so, he doesn’t have any recent “street cred”. 

The public sector, not only in China but all around the world, has taken on much of the private sector’s debt burden. This is exactly what needed to happen to avoid a depression. The self-righteous critics who clamor for the “failures demanded by free market capitalism” never take the analysis to the point of explaining exactly how much misery would have needed to be endured in the name of capitalism, should a depression have been allowed to proceed. China clearly was the most successful country in using its fiscal stimulus to avoid a downturn in GDP. Because of this, it is theorized that they have put their country at risk, having promoted too much growth and too much inflation in asset prices. The empty city video on YouTube is making the rounds. Most recently, the market has been spooked by the Chinese central bank’s desire to slow down bank lending. Bears view this as validation that the bubble is set to explode.  As a long term investor, I view the Chinese central bank restraining loans as exactly what I would like to see happen!

I think it is a 450 million-to-one shot against this being a long term bubble ready to pop. The 450 million represents the people that have been brought from rural and nomadic existence into a fully integrated role in the Chinese economy over the last 31 years.  It is highly likely that another 300-400 million workers will be brought into the Chinese economy over the next couple of decades. 

 It’s very hard for me to bet against a central bank that is sitting on a $2 trillion surplus. Is it possible to short specific Chinese stocks and make money? Absolutely! Is the Chinese Market thin compared to the U.S. market? Absolutely! Will corrections in the Chinese market be bigger than those in the U.S. market? Absolutely!   However, I think the right question is if you invest the same amount of money in each market and hold it over the next ten years, would you make enough extra money in the Chinese market to have made up for the extra volatility? I also think the answer to this question is yes, absolutely!  

I don’t believe a Chinese bubble will burst, nor do I believe that any set back in China will implode the worldwide economic recovery now under way. The only double dip recession I’ve witnessed in our economy came about in 1980-1982. This was engineered by Reagan and Volker working in tandem to break the back of inflation. It didn’t happen by accident, it happened under the burden of a significant real interest rate. We’re currently at a zero cost of money in the U.S. and that won’t turn into a real interest burden for a couple of hundred basis points. It probably couldn’t break the back of the recovery until fed funds got to 3 ½ or 4 %. The Fed has made it clear that they will be slow and steady when they begin to apply the brakes. 

Is the commercial real-estate market going to break the back of the already weakened banks? I don’t think so. This isn’t equivalent to the mortgage meltdown of 2007-8. The banks can see this coming. The big banks are still accruing billions of dollars of additional loan loss reserves each quarter. These reserves are being earned by generating a big net interest spread on a cost of funds of zero applied to a healthy prime rate. The banks won’t want to hold commercial properties that come up for refinance but they will have the wherewithal to sell them to vultures and write them down against the reserves taken. 

As you’ve probably concluded, I don’t think the bull market is over. Are we in a big correction now? Maybe we are, or maybe it will be somewhat limited. The main investment strategy position we’re taking is buy the correction when it’s done. We are in the early part of the business cycle recovery and the “Wall of Worry” is being built as well and as evidently as is often the case. 

Fred S. Fraenkel
Vice Chairman and
Chairman of Investment Policy
Beacon Trust Company

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