Bull vs Bear Q & A: Rosenberg vs Paulsen

A: Interesting piece out in the journal interviewing David Rosenberg and James Paulsen. With my time completely dedicated to finishing this project, I'll be referencing more macro articles over the next few weeks. I am definitely in the Rosenberg camp on this one.

Via The Wall Street Journel's, "A Mid-Year Bull vs. Bear Investing Smackdown":

Q: Where is the market headed the rest of this year and over the next 12 to 18 months?

PAULSEN (the Bull): Investor optimism, which got ahead of itself in early spring, has been checked, considerable liquid asset holdings are on the sidelines and concerns about a potential double-dip recession seem overblown. Recently the dividend yield on the Dow Jones Industrial Average rose above the 10-year Treasury-bond yield for the first time in decades, and the price/earnings multiple on year-end estimates has declined to about 13.

With interest rates and oil prices down, earnings still rising and policy officials showing no inclination of taking the punch bowl, the upside potential for stocks is encouraging.

ROSENBERG (the Bear): The market is not cheap. By the end of secular bear markets, stocks trade no higher than P/E multiples of 10 and at least a 5% dividend yield. We very likely have quite a long way to go on the downside.

The market moves in cycles -- 16- to 18-year cycles, in fact. This secular down-phase began in 2000. The best we can say is that we are probably 60% of the way into it. In a secular bear market, rallies are to be rented, not owned. We're in a primary bear market, not unlike what we endured from 1966 to 1982. Back then, the principal cause was inflation; this time, it's deflationary debt deleveraging.

Within the next 12 to 18 months, I can see the Standard & Poor's 500-stock index breaking back below 900 [it's currently at almost 1100]. A substantial test of the March 2009 lows cannot be ruled out.

Q: What should investors keep an eye on?

PAULSEN: The job market will likely determine conditions in the stock market during the balance of this year. Either job growth will soon accelerate or concerns about a double-dip recession or a crawling recovery will overwhelm stocks.

ROSENBERG: The economic recovery phase is behind us. The boost to growth from the inventory bounce has run its course and the stimulative effects of fiscal policy will diminish amid a public backlash against increases in government debt. That constrains the government's ability to try to fine-tune the economy.

Even if we manage to avert a double-dip recession, the chances of a growth relapse in the second half of the year are higher than the equity market assumes. The U.S. unemployment rate will stay near double-digit terrain, and inflation and interest rates will remain low.

A market priced for peak earnings in 2011 could be in for some pretty big disappointment. We'll see that with guidance from companies when second-quarter results stream out in the next few weeks.

Q: What should investors do with their portfolios?

PAULSEN: We recommend sectors most sensitive to the economic cycle, such as junk bonds and energy, materials, technology and financial shares, which have been left for dead. Now that China is done tightening, the emerging-market story may regain prominence. Cash offering zero returns (with today's ultra-low interest rates) and relatively "risk-free" 10-year Treasury bonds at a 3% yield don't offer much. Defensive economic sectors like health care are relatively overvalued. We like small-cap stocks and industrial stocks longer term, but both also seem a bit overvalued.

ROSENBERG: My primary theme has been SIRP -- "safety and income at a reasonable price." Yield works in a deleveraging deflationary cycle. The median age of the boomer population is almost 55, there is very strong demographic demand for income and with bonds comprising just 6% of the household asset mix. So appetite for yield will expand.

Within the equity market, squeeze as much income out of a portfolio as possible -- a reliance on reliable dividend yield and dividend growth makes perfect sense. Gold makes up a mere 0.05% of global household net worth, so small incremental allocations into bullion or gold-type investments can exert a dramatic impact. And central banks, selling during the higher interest rate times of the 1980s and 1990s, now are reallocating their reserves toward gold, especially in Asia.

Q: What makes you most enthused about the investing environment?

PAULSEN: If 2000 was the era of "irrational exuberance," today must be the era of "irrational pessimism." Too many are too pessimistic and are greatly underappreciating potential investment returns.

ROSENBERG: We are entering into a period of stable consumer prices that should last at least for a generation. This will help prevent erosion in real household incomes.

Q: What could happen that would turn you into a bear/bull?

PAULSEN: I could become a bear again if the massive policy stimulus introduced during this crisis prove too highly inflationary. That could raise bond yields, force more extreme Fed tightening and lead to a collapse in stock P/E multiples.

ROSENBERG: Signs that the debt deleveraging cycle has run its course. A new "killer app" or major technological breakthrough. A sustained decline in oil. Structural economic reforms in the world's "surplus saving" countries like China, India and Germany that stimulate their domestic consumer spending. Progress toward working our way though the repair process of the balance sheets of domestic households and businesses.

Interesting to hear Paulsen's last bit on becoming bearish if inflationary pressures start to creep in, causing bond yields to rise. Many, including yours truly, have discussed the 'end game' of this crisis and actions taken to stem this crisis as being a collapse in bond markets sending yields much much higher. But that phase seems to be years away. Right now, deflation is the main concern and the drive to safety is constraining US bond yields. That game lasts until the market starts to perceive the safety of US Treasuries in a different way. Think Greece, Italy, Spain, and Portugal. Sure we are the great US of A, but you never know when the markets may force the fed's hand and start sending the longer end of the curve for a ride. Again, I think that is years away and deflationary pressures are still in the pipeline for us to go through first. Perhaps a 2012-2013 issue. Maybe later.

As for the reflation, it was always built on an unstable foundation of stimulus and a fed engineered dollar carry trade. So of course it would not last forever. The difference I find myself in lately with colleagues and friends about these topics, was the artificial and unsustainable nature of that reflation; whereas many looked at the rebound as a solid, economic recovery. Clearly this seems not to be the case. We are yet to see the unintended consequences of all the policy actions taken to stem this deflationary debt crisis. For now, its kick the can down the road as long as we can. As many wall street trades tend to go, that works until it doesn't anymore.