The Bull And Bear Fight - A Look Forward For the Second Half

As we head into the second half of the year, let's take a look at the case for Bullishness and Bearishness.

First, the Bull Case, if only because I think its simpler.

To be Bullish on equities you need to believe that:

• The subprime mortgage issues will remain contained to subprime issuers and will not materially harm either primary broker/dealers or the credit markets as a whole. That is, you can have a lot of "New Century" blowups, but you can't have Bear Stearns implode. Nor can you have credit spreads generally widen out much from where they are now.
• EPS growth will continue at a reasonable pace; perhaps not double-digit but certainly high single-digits on a quarter-on-quarter basis.
• The consumer will continue to spend and this growth in spending is sustainable, which means that the consumer needs to have his wealth grow at a rate which exceeds his spending growth, whether from wages or otherwise.
• Housing will stop being a "drag" on consumer spending and GDP growth, and the housing market will recover before it does critical damage to the economy.
• Presidential Cycle market psychology. Third years of Presidential Terms have been historically very strong in the equity markets. In fact, it is rare to have a down year.

To be Bearish on equities you need to believe that:

• $1 Trillion in resets in 2/28 ARMs will occur this summer, and the ALT-A resets start to get really nasty in 2008. You must believe that this will continue to degrade mortgage-backed debt of all kinds (RMBS, CDOs, etc) and will spread well beyond the confines of mortgage companies.
• The Bear Stearns hedge fund implosion is just the first of many to come. They haven't happened yet because of intentional concealment, not because the problems aren't there.
• Housing has and will continue to be a drain on GDP and consumer spending, and the market in general will not start to recover for housing until 2009 at the earliest, perhaps as late as 2010 or 2011.
• Consumer spending is slowing already and this will continue, turning negative in Q3 and continuing at least through Q4, due to the lack of spendable income increases.
• Real borrowing costs will rise precipitously as spreads widen and risk is priced back into the market. This then shuts down the LBO and P/E funding marketplace, or so severely crimps it that the profit margin for these firms are severely damaged.
• We're up so far in the first half of the year that sustaining that sort of "run rate" is simply unreasonable. In fact, it would be parabolic.
• The Presidential Cycle theory does not apply because (1) we have a horribly unpopular President, (2) we have a historical oddity - no "heir apparent" in the race; this hasn't happened in a very long time, and (3) it is most likely that we will see a "tax and spend" Democrat win the White House, while they will maintain both Houses of Congress. This combination has no correlation with history and thus neither does the indicator. We are also coming off a business-friendly mix in the executive and legislative branch (since the '94 Republican Revolution - the current Bull really took off starting early in '95) that will help derail The Bull Market and usher in a secular Bear. In fact, this tectonic shift in the makeup of the US Congress and White House - for the first time since 1994 - is the longer-term reason to be Bearish on the markets IF we get a Democrat President.

That's the ying and the yang of it as I see it.

The one issue that I haven't raised before (here, but I have in my other blog in the past) is the issue of politics and how it relates to the markets. We have seen an absolutely incredible bull run in the markets in the last 10-12 years. One must look for why - what has really changed? Yes, "The Computer" came to the fore - or did it? Remember the personal computer made its debut in 1981, and the inevitable "more capability for less money" train began immediately.

So what really drove this huge bull market?

Washington.

In 1994 The Republicans threw the Democratic Congress out of office. Remember Contract With America?

The Democrats had held a 40+ year stranglehold on the Congressional arms of power. While we had both Democrat and Republican Presidents, Congress was firmly in the control of Democrat majorities.

Gridlock is good when it comes to Washington. Ideally you want a split of power that makes it impossible to pass bills that do not have strong popular support.

The worst possible case is a Democrat clean sweep. Such a change will lead to tremendous increases in both taxes and spending - which will inevitably drain the liquidity pool and lead to lower equity prices. Count on it. While I would love to say that I don't see it happening, I'd be lying - I do see it happening. How does this not happen? If there are one or more major terrorist attacks in the coming months. But those will rattle the markets too - a no-win, at least in the short-to-intermediate term.

I am, for now, solidly in the Bearish outlook camp on a credit, economic, valuation and political outlook basis.

I believe we will see a recession, and that it will be evident in 3Q; we may be in one now but you can only call one in retrospect.

I further believe that while not everything in the investing world will turn into a turd, we are looking at a repricing of risk that will take 20-30% off the market indices.

In the longer term we have more trouble ahead, but that's not coming for a couple of years. In the "here and now", if we get a 20-30% downward move in all probability I will shift back to the Bullish side for a while, as I do believe the markets are not "done" overall - that is, we're not about to see a permanent bear market - just one that comes home to roost through the rest of '07 and probably well into '08.

When will it turn in the broader markets? About six months before the housing market shows signs of actually bottoming. This, I believe, is not in the cards for '07 at all, and is unlikely to happen in '08.

Note that markets can go up during a bear market - for a while. There are counter-trend rallies that happen all the time, just as there are swoons that happen during bull markets.

The only remaining issue for me is one of timing - when will people be forced to 'fess up to the mess on their balance sheets. What has become clear over the last couple of months is that market participants will do nearly anything to avoid that.

This tells me one thing above all else - this is not a minor problem nor is it contained. If it were either market participants would be in a huge hurry to take their (minor) pain and put it behind them. That they are steadfastly refusing to do so, even in the face of overwhelming evidence that it exists, tells me that the pain is far worse, and the damage far worse, than they have admitted to.