Yesterday's post set off a flurry of comments, most of which were telling me how wrong I was. But fortunately it was all very reasoned, and I'd like to thank every one who posted a comment for contributing to the blog.
I wanted to reiterate that I don't find anything wrong with being bearish. While I'm not terribly bearish right now, I do think the odds of recession are fair, and perhaps the stock market hasn't pricing that in properly. I honestly don't spend a lot of time thinking about whether the stock market is fairly valued or not. I do spend a lot of time on credit spreads, and those tend to correlate with stocks, but that's honestly about it. For what its worth, the money I've allocated to stocks stays invested at all times, and I rebalance regularly, regardless of my market view. I have some trading strategies I employ for my own money, involving all kinds of cute things like technicals and leverage and short selling, but its all bond related. I'm not a stock guy. I just know that stocks usually go up, and I like those odds.
There is a real difference between being bearish because some asset class is currently somewhat over valued and expecting a financial apocalypse. The former is looking for a correction, which are fairly common. The later is looking for something that has very rarely or possibly never happened before.
And here is the problem with forecasting something that hasn't happened before. You don't know when to conclude that it isn't going to happen. Take consumer debt loads. By some measures, consumer debt is extremely high. This leads some to conclude that a day of reckoning is forth coming. But the problem is that consumer debt has been high for a long time. By at least one measure consumer debt has outpaced GDP by a full 1% over the last 20 years. So if one held that consumer debt was too high, you could have held that opinion for the last decade. And yet until just now, there hadn't been any problems with consumer debt. If you had stayed out of the stock market from 1997 to 2007 you would have missed out on a 92% return. This despite a
historically bad bear market in 2000-2002. And even today, the jury is still out on how badly this will impact the stock market. So far its been very little.
As some commenters pointed out, bears also need to know when to get back in, which is very difficult. Say you had been bearish on stocks because you felt they were "irrationally exuberant" in December 1996 (Greenspan coined the phrase in a speech on 12/5/96). From 12/5/96 to 3/31/00 the S&P 500 advanced 111%, or about 25% annualized. But you stick with your theory, its just getting more irrational, you think. Then things start turning your way. From 3/31/00 to 9/30/02, stocks fall 44%. Do you re-enter the market? Well the S&P was at 744 on 12/5/96 when you decided to go bearish. It hit a low of 777 on 10/9/02. But still above the level where you determined things were "irrationally exuberant." Can anyone reading this honestly say they would have known to exit their short then? Of course, we know the rest of the story. Stocks are up 15% annualized in the nearly 5 years since 9/30/02.
Several commenters advanced something to the effect that periods of financial innovation end badly. Let me give you an example. In the 1980's part of the stock market boom was the burgeoning LBO market, which was made possible by the growing junk bond market. The junk bond market as we know it today was basically invented by Drexel Burnham and Michael Milken. Prior to this "innovation" junk bonds were almost exclusively fallen angels.
As readers undoubtedly know, in 1989, Milken was indicted on various securities law violations. Drexel would declare bankruptcy in 1990. Drexel had dominated the market making in high-yield debt, and therefore their exit ushered in a period of horrible liquidity in junk bonds. It would have been very easy to conclude that the popularity of junk bonds was just a fad, and that we would soon return to the previous norm of junk bonds being mostly fallen angels.
Meanwhile, junk performed very poorly. From September 1988 (when the SEC first sued Drexel) to February 1990 (bankruptcy) junk bond prices fell more than 12%, based on the Merrill Lynch High Yield Master. (Total return was still positive at 1.6%). The S&P 500 was up more than 26% during this period. For the rest of 1990, junk continued to fall, losing another 12% price wise, and falling about 1.7% in total return.
Whatever happened to the junk market anyway? Oh yeah, its still going strong. In calendar 1991 the high-yield market returned 39% and hasn't really looked back since. See, the innovation was a good one. Was Milken and Boesky and those guys all crooks? Sure. Did it end badly for them? Hell yeah. Would you have been wise to avoid stocks (or high-yield bonds) even had you predicted their downfall? Only if you timed it just right.