‘Science’ or ‘Faith’ And the Bear or Bull Market Case

by Michael A. Gayed | November 4, 2013 5:00 pm

“Science never solves a problem without creating ten more.” – George Bernard Shaw

Fans of the television series Lost may recall an episode entitled “Man of Science, Man of Faith” in which two of the shows leading characters represented opposing views of the world, one based on science (Jack Shephard) and the other based on faith (John Locke). In today’s stock market, we have a similar divide.

The “Men of Science” today are primarily in the Bearish camp, using the following arguments to justify their position:

• Elevated Valuations: The Shiller P/E ratio for the S&P 500 of 24 is higher than 90% of other time periods. While not a good predictor of short-term returns, it has been one of the best predictors of long-term returns. Historically, returns following such high valuation levels have been well below average over the next 7-10 years.
• Slowing Earnings/Revenue Growth:  Year-over-year operating earnings growth for S&P 500 companies has been below 1% for the last 3 quarters. If you exclude share buybacks, the growth rate turns negative. Multiple expansion has replaced earnings growth as the primary driver of returns.
• Record Profits Margins at Risk of Mean Reversion: With corporate profit margins at an all-time high, they have nowhere to go but down. When they inevitably revert back to the mean, this will put additional pressure on earnings and therefore stocks.
• Lackluster Economic Growth: Despite the easiest monetary policy in history over the past 4+ years, economic growth remains subpar. Year-over-year real GDP growth of 1.6% is at a level more commonly associated with an economy entering a recession than in the fourth year of an expansion.

Meanwhile, the “Men of Faith” today are primarily in the Bullish camp, using the following arguments to justify their position:

• Don’t Fight the Fed. The Fed will continue to increase its balance sheet at $85 billion per month and maintain 0% interest rates as far as the eye can see. This is bullish for stocks.
• Bernanke Put: The Fed’s policies have created a floor underneath the market, making stocks a lower-volatility investment. The market cannot suffer a significant decline as long as the Fed is supporting the market with unprecedented measures.
• Wealth Effect: Eventually, the Fed’s wealth effect will take hold: higher stock prices will boost consumer wealth and help increase confidence, which will spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
• Greater Fool/Dance until the Music Stops: The market can remain irrational longer than the Bears can remain solvent. Valuations do not matter in the short-run. This could very well evolve into another bubble like the late 1990’s, in which case stocks are still cheap in comparison. The music is still playing and there are many greater fools to sell to at higher prices.
• Cash is Trash: Cash is paying nothing and interest rates on bonds are at record lows. Equities at least give you a chance to keep up with inflation.

What is the average investor to make of this heated divide? Should one invest based on science or faith? There is not a simple answer to this question. Ultimately, both can play a role but not in the conventional way of thinking.

Long-term investors need to have faith not in bullish/bearish pundits but in their own investment plan/process; sticking to a plan/process is critical to investment success as we are emotional beings that are wired to buy high and sell low when we should be doing the opposite. At the same time, any investment plan/process should also be based on some level of science, ranging from the simple concept of diversification to the more complex quantitative investment models.

As for permanently aligning with the bullish or bearish camps of the day, I would highly dissuade anyone from taking such an approach. As the investment opportunity set is constantly changing, there are times that warrant more bullishness and other times that warrant more caution.  Its why our ATAC models used for managing our mutual fund and separate accounts buy and rotate rather than buy and hold.  Sure, 2013 has been a great year for stock investors.

How will next year play out?

Strategy, strategy, strategy…

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

Source URL: https://investorplace.com/2013/11/science-faith/

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