One important factor in this outperformance is that fund managers have switched from favouring Europe to the US. The latest survey from Merrill Lynch, published on July 17th, confirmed that most fund managers think that the US markets will perform best over the coming year.
It will probably be necessary to wait till the third quarter to see if the US economy is turning this year or not. For now investors will have to rely on experts’ arguments.
But, fund managers and other experts have been wrong before,
which is why it is worth considering their arguments. Below the most common arguments for and against an economic recovery are given a grade between 0 and 5 points. The arguments have been taken from the latest half-year report from Lansforsakringar [one of the biggest asset managers in Sweden].
The bulls’ arguments:
1. Continued aggressive rate cuts increases the money supply, which usually is positive for shares.
This is a very strong argument. The six rate cuts made by the US Federal Reserve during the spring will, according to economists, take effect with a delay of six to nine months and will start stimulating the economy during the autumn. The question is whether the rate cuts are enough to get investment going to keep unemployment from continuing to increase. (5 points)
2. Buying after big falls is usually a good strategy. Investors tend to be most negative when the profit outlook is adjusted downwards and when negative economic data is released.
This is a bad argument. There is no proof that last year’s stockmarket fall is over. If it takes another year to reach the bottom, it is of course a bad idea to invest today. It is usually only afterwards that one can say for sure where the bottom was reached. (0 points).
3. This is just a normal weak economic cycle. It will turn during the autumn and profits are close to the bottom.
This argument is built on a comparison to earlier economic cycles in the US after the war, which all have lasted about a year. Economists point to several differences in this latest downturn, one being that it did not start with overheating demand and increasing inflation, but rather the bursting Nasdaq-bubble and falling investments. It is therefore uncertain that the normal pattern will be valid this time. (3 points).
4. Investors’ willingness to take on risk is starting to return.
It is uncertain if this is true today, even if it was true a month ago. Share prices and prices on other risky investments are higher today than in April, meaning that there are investors who believe that the bottom has been passed. There is, however, no logical connection between this fact and the future development of share prices. (0 points).
5. Expectations on technology and telecom companies are too low. We are in the beginning of a new technological era.
There are definitely many benefits from the new technology, which should increase productivity. But history is a long chain of new discoveries and inventions making it difficult to say that this is a new era. Share prices are lower than just before the bursting of the Nasdaq-bubble, but still higher than two years ago. (3 points).
The bear arguments:
1. Technology investments have been unsustainably high in recent years. The normalisation after this extreme Internet speculation risks taking a long time.
Even if the current recession in the IT sector ends next year and investment increases again (in number of units) it is likely that prices, profitability and margins will have a hard time to recover. Also, technology and telecoms account for a large part of world market capitalisation. (3 points)
2. American consumers will reduce their spending.
Most experts see American consumers as the key to economic growth, not only in the US but also globally. It is clear that it is growing more slowly today than it was a couple of years ago, but the question is if it will decrease. A tax reduction is one argument that implies that consumption will continue. But, increasing unemployment, increased savings, lower share prices and a lower bonus at the end of the year imply that consumption should decrease. (5 points).
3. Most investors expect an economic recovery in the autumn. This is almost certainly already discounted in today’s share prices. There is a significant risk that commentators are wrong.
This is a strong argument. When Alan Greenspan, the chairman of the Federal Reserve, warned of a delayed recovery in a testimony to a congressional committee the stockmarket fell. (5 points).
4. Profits and profitability are still high, which is not sustainable in the long term.
It is clear that an important reason for the rising stockmarkets in the 1990s was increasing profits and high profitability in listed companies. According to economic theory profitability should fall over time. But such an adjustment can take a while so the argument is only a warning that the trend of rising profits has been broken. (1 point).
5. Unsustainable faith in the future for shares has created one of the longest and strongest stockmarkets in history (1992-2000). It could take many years before expectations return to justified levels.
This is an argument that is hard to analyse. Expectations could get stronger, and make people invest more in shares, so stockmarkets could rise. Expectations could also weaken, which would hit share prices. As the valuation of shares is still high in historical terms the risk of falling prices seems to be greater today. (2 points).
Looking at the sum of the points for the bulls and the bears gives the former 11 and the later 16. The bears seem to have the stronger arguments.
