A Bear Believes That the Bulls Are on Serve

by Tom Au

In tennis, having the right to “serve” (put in play) the ball is a decided advantage, so players alternate serves between games, sharing this advantage. Between two almost evenly matched players, whoever serves will win most games, by “holding serve.” But in the typical “set,” the better of the two players will win an occasional game while the other person is serving, a result that is known as “breaking serve.”  This, together with the fact that he or she is serving half the time and (presumably) holds all serves, means that the slightly better player will likely win the set by getting a majority of the games with a score of say, 6-4. If a player both holds serve and breaks serve consistently, the result could be a more lop-sided 6-0 tally that clearly demonstrates who is the better player.

In the U.S. stock market, the “serve” is determined by the election cycle, with bears getting the “serve” in the first two years, and bulls getting the “serve” in the last two years. Despite “having serve,” bears like me lost in 2005 and 2006. Or to put it another way, the bulls “broke my serve.”  The next two years in the election cycle, 2007 and 2008, feature the bulls on serve. Oddly enough, between the two sets of years, it is during the “pre-election” years, like 2007, 2003, 1999, 1995, etc. (when the incumbent party is pumping up the economy to maximize the chances of re-election), that the market is more likely to rise, not the election years themselves.

Still, there are a couple differences between the stock market and tennis. The first is that order of magnitude counts in the stock market, more than in tennis. Suppose there was a three set (usually woman’s) match, where one contestant posted set scores of 6-4, 0-6, 6-4. The first contestant would win the match, two sets out of three. But in the example I constructed, the second contestant actually won more games, 14-12, because of the lopsided second set. To most investors in the market, this would be the more important point, because they’re more concerned about the cumulative size of their wins rather than the frequency.

The second difference is that the bears in the stock market win the ties – because of inflation. On this basis, maybe the bears had a point in 2005, at least. From 1966-1981, the market went up in nine of sixteen years (a majority for the bulls) and essentially went nowhere in nominal terms. But the bears were more nearly correct, because the market went down big time in inflation-adjusted terms.

My cautious optimism for 2007 is supported by one of the bulls’ main arguments: that the strong earnings growth of the past few years has dramatically lowered P/E multiples, leaving room for “catchup.”  On the other hand, I’m still basically of the “Kassian” view that the U.S. economy is fundamentally weaker today that in was in 2000. Hence my belief that we won’t go anywhere near a new high in P/E ratios, or even reach inflation-adjusted levels of that year (which would imply a lower multiple of higher earnings).  I’m mentally “capping” the Dow at 14,000, just below those levels, and disagree with another street.com commentator* who predicted a 16,000 Dow for 2007 (a 2003-like gain of almost 30%) – unless we have a double-digit inflation that makes 16,000 the new 14,000.

Under other circumstances (i.e., if the Presidential election had just occurred in 2006), I’d probably be a bear right now. The tie breaker was where we are in the election cycle. Even so, the mid-term election rally started earlier last year than in other similar years, thereby dampening this year’s likely returns relative to its “peer group” (other pre Presidential election years). Since it rose last year, I believe that there will be no more than a 15% gain in the S&P 500 for all of 2007, compared to the historical average of about 23% in pre-election years, and the 30%-ish advance that often takes place when the preceding year is down. And as this is the twentieth anniversary of 1987 (the last pre-election year ending in “7”),  I wouldn’t even rule out a similar result – a strong rally on momentum followed by a crash on fears of overvaluation that leaves a single-digit net gain for the year.

In fact, stocks have gone up in every pre-election year for the past century except three – 1907, 1931, and 1939. The first year featured the short but severe Depression of 1907 that ultimately led to the creation of the Fed in 1913 (because J.P. Morgan & Co., the nation’s de facto central bank in 1907, couldn’t do the job). The second year was in the depths of the 1929-1932 bear market that signaled the onset of the Great Depression; and the last year marked the start of World War II. So a market decline in a year like this could have very serious implications. Even I, one of the biggest bears on the site, don’t think that it will get that bad, because the bulls are not only “on serve,” but have the (pre-election year) “wind at their backs.” (Tennis players also alternate sides of the court so they get an equal amount of sun, wind, etc.) In 2008, the bulls will still “have the serve,” but with the election year “wind in their face,” as in 2000, which is why the bears are somewhat more likely to “break serve” next year. But if my cautious optimism for the coming year proves to be unwarranted, it is likely to mark the start of another Great Depression – or World War.

Editor’s Note: Thomas P. Au, CFA, is a principal with R. W. Wentworth, a financial services firm in New York City. Earlier he was an emerging markets portfolio manager for the investment arm of Cigna Corp. and an analyst with Unifund, S.A. of Switzerland and Value Line. He graduated cum laude with a B.A. in Economics and History from Yale University and an M.B.A. in Finance from New York University. Mr. Au is the author of “A Modern Approach to Graham and Dodd Investing.”

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