Why the Bears Are on the Way Out

Economies and equity markets around the world have bounced back from the depths of the abyss of the Great Financial Crisis of 2008. But many wise, battle-tested, and highly respected gurus remain bearish about the extent and staying power of the recovery, the medium-term outlook for the big Western economies, and future returns from stocks. Phrases like "dead-cat bounce," "house of cards," and both "stagflation" and "depression" crop up in their pronouncements. They point to a tapped-out consumer who has pigged out on debt, a minuscule savings rate, a financial system that remains egregiously overleveraged, and governments and central banks that have shot their wad.

Many of these skeptics correctly anticipated the crisis, and as a result they have deep credibility. Nouriel Roubini, an economics professor at New York University, saw the abyss early and remains gloomy about the economy as well as the equity market. Stocks have risen too far, too fast, he says, and deflation and big trouble are ahead. Bill Gross, the most respected bond manager in the world, speaks of "a new normal economy of slower growth, muted profit gains, and … dollar devaluation." He believes equities will have low returns in the years to come. The International Monetary Fund, not usually a pessimistic prognosticator, intones: "The path of output tends to be depressed substantially and persistently following banking crises, with no rebound on average to the pre-crisis trend over the medium term." George Soros speaks of "a generation of wealth destruction."

Given this backdrop, the bears anticipate slim pickings from equities in the next five to 10 years. They point out that stocks have already rallied 55 percent off the March bottom—and at 14 times next year's hoped-for operating earnings, they're fairly valued at best. As for the future, if the U.S., with all its problems, can generate real GDP growth of 2.5 percent a year over the next five years, it will be doing well. If you assume inflation of 1 to 2 percent, nominal GDP of 3 to 4 percent, and corporate profits and dividends rising at 4 percent per year, why would you expect any more than annual returns of 4 to 5 percent from U.S. stocks? Higher tax rates on profits, incomes, dividends, and capital gains—which seem inevitable—are additional headwinds. Europe and Japan have shrinking workforces, sick banking systems, and low productivity growth; their GDP growth rates almost certainly will be even more anemic.

These are all compelling arguments. They appeal to our sense of the Puritan ethic. It's time to pay the proverbial piper for our spendthrift ways. The West, particularly its greedy bankers and hedge-fund managers, deserve a good flogging. Furthermore, forecasters always find it easier to extrapolate the most recent past into the future. Stocks have been an awful place to be for years. Since the spring of 2000 U.S. equities (adjusted for inflation) have lost almost half of their purchasing power. Treasury bonds, a much safer investment, have actually done far better, beating stocks by 9 percentage points a year. In fact, Treasuries on a total return basis have had a higher return than stocks for more than two decades. This is unprecedented. All of us, investors and economists alike, have been fighting monsters at the precipice for years, and our psyches are shattered. Remember what Friedrich Nietzsche said: "Whoever fights monsters should see to it that in the process he does not become a monster. And when you look long into an abyss, the abyss also looks into you."

So what makes me guardedly more optimistic? First, history. In the turbulent, war-ridden 20th century, in spite of all the trouble, stocks in America had a real (inflation adjusted) return of 6.9 percent a year versus 1.5 percent for Treasury bonds. In the U.K. the comparable numbers were 5.8 percent versus 1.3 percent. In Japan, they're 4.5 percent versus minus 1.6 percent. Equity investing is the wellspring of economic growth, and financial theory maintains stocks have to generate positive real returns—and real returns that are significantly higher than government bonds, which are both less risky and less volatile. For capitalism to work, it can't go on like this. Since he takes more risk, the owner has to earn more than the lender.

Moreover, history in the U.S. and elsewhere shows that past periods where stocks suffered losses and bonds outperformed have been wonderful times to buy stocks and sell bonds. In the U.S. there have only been three such periods.

The first was after the second quarter of 1932. Gloom was everywhere. Discouraged investors knew the world was in depression, capitalism was a failed religion, unemployment was 25 percent, and Nazi Germany was rising. The S&P thereupon delivered a whopping 34.8 percent compounded annual return over the next five years.

The second was in 1949. The budget deficit as a percent of GDP was far higher than it is today, the economy was stalled, a postwar depression was anticipated, communism was a spreading plague, and the Soviet Union was a deadly enemy. Stocks soared 23.2 percent a year for the next half decade. In both instances, the return from Treasury bonds was pitiful.

The third and final period was an interlude of agony from 1966 until late 1980. The S&P and the Dow wandered aimlessly as the U.S. economy suffered from inflation and stagnation. Initially gurus said equities would be a great inflation hedge, but as it turned out their real value was ravaged by inflation. Nothing seemed to go right at home or abroad: Vietnam, Watergate, the Iran hostage fiasco, and corporate scandals. Nevertheless, there was fire in the ashes, and in 1982 an 18-year bull market began.

What could the pessimists be missing today? First and foremost, they are betting against America, the greatest entrepreneurial engine ever created. History says buy America when it's down. In addition, emerging economies may well be the new dynamo of growth. They now account for 35 percent of world GDP and are growing two to three times faster than the developed world. S&P 500 companies now collect almost 50 percent of their revenues from overseas, and almost half of that portion comes from these fast-growing developing countries. Another factor could be that stocks currently despite the rally are still deeply undervalued. The rule of thumb is that stocks should sell at a price/earnings ratio equal to 20 less the inflation rate. Assume S&P 500 operating earnings are $70 to $75 next year and inflation is 1 percent, you get a theoretical price far higher than the current level of 1060. If inflation rises in the future, price/earnings ratios will fall but profits will be higher.