For bears, being right still hurts

By Jim Jubak

Being a stock-market bear is excruciating right now.

It's bad enough taking a beating from constantly climbing stock prices. The Dow Jones Industrial Average ($INDU) and the Standard & Poor's 500 Index ($INX) are both up 7% this year.

But there's something even worse than losing money when you’re a bear: It's losing money while knowing that you're right. This stock market is overvalued, as these market pessimists argue. This rally is built on a flood of cheap money. Earnings growth is slowing. There are speculative bubbles all over the world, from the apartment market in Spain to the stock market in Shanghai. And yes, there will be a day of reckoning for the global financial system.

But in the meantime, while they wait for Armageddon and the days that will divide the prudent from the reckless, bears are getting killed.

Why it matters

It's important to understand why so that you don't tune out these important voices of caution or get scared out of the stock market years before it's necessary. It's likely that we'll have one of those run-of-the-mill seasonal corrections of 5% to 10% relatively soon, probably within the next month or three. The stock market looks increasingly overextended here, with the number of new highs on the New York Stock Exchange failing to keep pace with the new highs for the S&P 500. That often flags a coming correction, which, given the historical weakness of May and June following the strength of April, wouldn't be a big surprise.

But the kind of big "I-told-you-so" downturn -- a drop of 15% to 20% or more -- that the bears have been calling for could be as much as three to five years away.

Bears are notoriously early, of course. Yes, bearish pundits did call the bear market of 2000 to 2003, but they started to call it as early as 1995. An investor who heeded those early warnings and moved to the sidelines would have lost the chance to make a lot of money.

Bears are so frequently early in their calls because they have a rather admirable and idealistic faith in fact and logic. If they can show that global liquidity has been expanding at the kind of breakneck pace that always produces a crash, that earnings growth is slowing, that earnings-per-share numbers are overinflated and that housing prices are falling, then they believe that investors will act rationally and sell their investments. The markets will crumble.

For a group of investors that spends so much time decrying the irrationality of other investors, bears curiously underestimate the ability of investors to maintain their beliefs in the face of the bears' facts.

Slow on the uptake

Market history shows that overvalued and undervalued markets go to extremes of valuation because investors don't like to face facts until they've been hit over the head with them.

For example, it's amazing to me that the stock market has rallied for all of 2007 in the face of falling earnings growth rates. It looks like operating earnings per share for the S&P 500 companies will grow by 8% to 9% in the first quarter of 2007 versus the first quarter of 2006. That's certainly not bad but a drop nonetheless from the double-digit growth rates reported for the last 19 consecutive quarters. Eight times in that string, operating earnings growth rates topped 20% in a quarter. (We don't have final numbers for the fourth quarter of 2006, but it looks like earnings growth topped 10%.)

The market's rally gets even more perplexing if we look further into 2007. Forecasts now call for earnings growth to drop to 5% in the second quarter of 2007 (versus the second quarter of 2006) and to 2% in the third quarter.

These facts, logically, should have led investors to sell stocks rather than buy.

But bullish investors are perfectly capable of looking past this bearish logic. Some investors simply don't believe the numbers. After all, at one point this year it looked like first-quarter 2007 earnings growth might come in as low as 3%-4%, but that didn't happen. Many bullish investors apparently believe that real earnings will come in above projections again in the second and third quarters, keeping the rally going.

Other investors are apparently looking past the projected slowdown in second-quarter and third-quarter growth to the projected pickup in the fourth quarter. For that period, Wall Street analysts, according to S&P, are now projecting 14% year-to-year growth in operating earnings.

And a third group of investors is apparently willing to simply disregard these bearish facts. The earnings growth figures are irrelevant because of the continued boom in corporate buyouts, because of continuing low interest rates, because of continued cash flow into the U.S. market from overseas. Whatever.

There's more to the irrational behavior

These three groups of investors won't be convinced by the facts, no matter how many times the bears wave them around and no matter how many additional facts the bears muster to buttress their arguments. It will take a market downturn to get their attention. Then these facts, ignored or dismissed, may seem relevant.

Or maybe not.

Because there's another big source of irrational behavior in these market that bearish arguments tend to overlook.

To my mind, one of the strongest elements in the bearish case is the growing use of riskier and riskier kinds of debt to prop up everything from buyout deals to corporate dividend payouts. (For the role of risky debt in share buybacks and dividend payouts see my May 8 column, "How cheap debt overinflates stocks.") The leverage in buyout deals is increasing, the junkiness of the junk bonds used in these deals is increasing, the amount of debt on balance sheets is increasing and the use of complex and sophisticated, but untested, derivatives to insure against loss in these deals is increasing.

Yes, this is a debt bubble, and at some point it will pop.

But those bears calling for it to pop soon are underestimating the degree of irrationality now coloring the thinking of CEOs, CFOs and investment bankers. Yes, it makes no sense to borrow money to pay a dividend if you're running a growth company. And yes, this practice puts extra debt on the corporate balance sheet. And yes, a rational CEO would recognize the danger signs and stop playing the game, putting an end to the rally in stock prices based on this risk-taking behavior.

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