How Strong is the Bear Case?

The bear case became a lot stronger starting with the 4-19-2014 article in Barron’s that interviewed Rob Arnott where he discussed just how weak real GDP is now and has been for a long time. Then widespread acceptance of the fact of low global growth and lack of credibility of any stimulus plans in the world, including QE, ZIRP further reinforce the bear case.

Just when talk got louder in 2Q2014 of a rate rise suddenly a few months later rates tumbled and the secular stagnation theory became widely accepted. Stocks broke through their 200 DMA in October 10, 2014 after doing an outlier increase of 32% in 2013 when it would be more appropriate to have only made a total return of 9%. Amazing how widespread the consensus was before 4-2014 of classic recovery of employment and growth and inflation that would materialize in December, 2014 or mid-2015, now it is starting to look like rates won’t go up until 2016. But EU and Japan are starting to look shakier and China isn’t getting better. Oil price collapse and EM commodity weakness undermine EM economies which could set off a repeat of the July 4, 1997 East Asia debt crisis.

In the first quarter the consensus was that interest rates and growth could only go up. The consensus was almost unanimous about that. Noted ultra-bear Hugh Hendry had defected to a bullish view in Nov., 2013. The bear case was deeply out of favor.

The consensus now seems to have shifted to the view that China’s massive GDP growth rates are both dubious and likely to go lower which would be a huge disinflationary force on the global economy. It used to be that business stories about China talked about how wonderful growth was but now these stories seem to focus on improbable or unsustainable things like the fact that in a few years China imported as much cement as the U.S. used in a century.

Oil price decline is good for consumers but bad for over-leveraged junior oil companies, especially EM companies and EM countries that get royalties. EM oil exporting governments may be heavily dependent on a maximum oil price and failed to save for a rainy day. So the benefit of lower prices is helpful to the global economy but the risk is it is deflationary and may have dealt a fatal blow to heavily indebted companies and governments in that business. A consumer can weather the problem of paying an extra $40 a month for oil, but an over-indebted borrower who is dependent on a high oil price for survival simply can’t survive a long period of low prices. Consumers are so overstretched that they may simply use the $40 monthly savings from low oil prices to pay off debt while the small cap and small MLP oil producers encounter increased risk of defaulting on their debts. MLPs are forced to borrow because of tax reasons they are required to distribute profits to unit holders instead of retaining earnings for capital equipment needs. This makes them more susceptible to debt default risk than a typical public corporation.

I expect that the economy will continue to grow extremely slowly and that it will be a while before junk bonds get so overloaded with bad debt that they collapse and trigger a recession. If economic cycles last about 7 to 9 years then perhaps the next crash bottom would start in 2016 and bottom in 2017. The problem is that it is too risky to use momentum trading (which is based on simply riding along with a bubble even if there is no reason for a stock to be so high) or Greater Fool trading. This is because the market is more risky (due to being propped up by stimulus) than in previous cycles so it could crash harder and faster thus severely damaging traders who ignore fundamentals and advocate momentum trading.

Data about momentum trading may show it worked based on the past, but that was before the massive infusion of bubble-causing debt that occurred in the last 20 years. In the era before 1997 the financial economy was more sound and more fairly priced and less prone to a drastic meltdown. Any technical trading tool can become overused and start to fail. If it fails when you have bought stocks at Mt. Everest heights are you prepared to walk down to basecamp without bottled oxygen?

Investors need independent financial advice about the risks of not knowing about the risk of a bear market. I wrote an article “Increased debt fueled 17 year stock bubble”.

About the author

Don Martin

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