Bull Market Update

by

Ross M. Miller
Miller Risk Advisors
www.millerrisk.com
May 14, 2007

I have survived another year of life among the academics and as my "reward" I get to hang out with a bunch of Fed governors and their friends on a small island off the coast of Georgia soon after I post this commentary to the Internet. While my faith in higher powers occasionally wavers, the mere fact that I have been invited back to bask in glow of Ben and company is simply divine.

Having dispensed with hedge funds as the potential source of Armageddon, this year's Federal Reserve Bank of Atlanta research conference focuses on credit derivatives—a field where I can make a legitimate claim to having been present at birth. But I'll save such stories for the next commentary and focus my energies on the bull market.

These commentaries began in early 2004 with "The Bull That Will Not Die" and I revisit the bull whenever he needs comforting. By now, the we have gotten to be good friends and I have defended my bovine buddy against the likes of Bill Gross and Jeremy Grantham (who has only grudgingly come to see the wisdom of my position in recent weeks).

The main reason that I thought that the bull market would survive the 2004 elections and why I continue to believe that it will survive indefinitely is straightforward: The Fed has kept short-term interest rates too low throughout this young century. With real short-term rates currently poking their heads above an inflation-adjusted rate of 2% (the Fed may look at core rates, but people still have to use transportation, keep warm, and eat), the Fed has yet to tighten rates. The Fed has merely, to use their words, "removed accommodation." As long as the central bankers of the world lack the will to protect the value of their currencies at any cost, the liquidity that they hose out will eventually slosh its way into international stock markets. On the other hand, as the late 1970s demonstrated, excessive monetary laxness is bad for both stocks and bonds. The Fed's actions along with its anti-inflationary rhetoric would appear to be sufficient to prevent a repeat of a massive spike in prices and the pain required to get things back under control.

The best possible path for the Fed would be for prices to drop for exogenous reasons (low oil prices), which as CPI dropped would induce real tightening assuming the Fed stays on pause. (At 1.5% inflation, the current 5.25% fed funds rate would finally qualify as tight.) In the absence of such good fortune, the Fed may have to bring its current "pause that refreshes" to an end at some point by raising rates. Fortunately, that will not happen any time soon. Regardless of what various pundits and the futures markets say, the best bet for the remainder of 2007 is that the Fed will hold the fed funds rate at 5.25%. Will rates drop any time soon?—find the black swan and perhaps he can tell you.

The best news for the stock market is that people have begun to forget about the grim days of 2001 and 2002. It was those memories that sent liquidity in the misguided direction of real estate, especially of the residential variety. Homes are nice, but as places to live. Only prime residential real estate, which tracts houses in Las Vegas certainly are not, make sense for another other than short-term speculation.

Behaviorally, the stars are well-aligned for the stock market. P/E ratios may be too rich for the Buffetts of the world (they will have to wait at least until the Great Baby Boomer Cash-out for their next buying opportunity), but still well below nosebleed levels. Volatility is low but not as low as it used to be, which is also good. (While volatility still has the potential—for structural reasons—to go lower than its historic lows of last year, such an occurrence looks to be years away at this point.) Moreover, news stories abound about the market being too rich and investors lacking confidence. There is widespread pessimism about everything from Iraq to vanishing honeybees. And, finally, there are no signs of market mania.

Right now, I am waiting for the first buying panic to hit. A 100-point rise in the Nasdaq would do nicely. While such a move would mark the beginning of the end of the bull market, it would only be the beginning and would confirm that this bull market will be another monster. There is no guarantee that the bull market will reach that stage, but if it did it would be reassuring. While the stock market is currently seems ill-equipped to weather an increase in the fed funds rate, a more manic market could shake it off after the obligatory plunge knocks the wimps out of the market.

I could write more about the stock market, but why bother? I have all sorts of bizarre and interesting (to me, at least) that I have been dying to write about and they will fill my future commentaries. I have one more "serious" commentary left to go and then summer madness at Miller Risk Advisors will commence. It is quite possible that I will never write what could be construed as market prognostications again because it is most tempting to quit while I am—or perceive myself to be—ahead.