Monday, May 07, 2007

The Bearish Case

Last week on Kudlow & Co. on CNBC, I explained why I am bearish on the markets. It boils down to three things: 1) Slowing earnings growth, 2) Rising interest rates, and 3) Higher taxes.

There is no question that earnings are strong. Corporations have been doing great. Those that do a significant amount of business abroad have been doing particularly well. Some of this is due to strong foreign economies, but much of it is due to a weak U.S. dollar that keeps weakening on a regular basis. More importantly, however, corporate earnings growth is actually slowing. Furthermore, the growth in net earnings is significantly less than the growth in earnings per share. This is because of all the share buybacks going on. Corporations know investors focus on EPS. They also know they can easily boost EPS by buying back shares. I will interview S&P's Howard Silverblatt about earnings tomorrow. This MoneyMasters interview will be posted on on May 17.

Interest rates are a bit more interesting. I actually think there is a better chance the Fed will lower rates than raise them. But as we've learned in recent years, what the Fed does has little influence on the longer end of the yield curve. GDP growth has slowed considerably, and the most recent employment figures were disappointing. Results like these should make the Fed feel more comfortable about lowering interest rates. However, I continue to worry about rising energy prices. Gasoline prices are near an all-time record. Although I expect them to back off a little from this level, they certainly aren't going to plummet. Eventually they will feed inflation causing the yield on the 10-year note to rise. Furthermore, I also believe credit spreads will widen.

Finally, there are taxes. I often laugh when I hear liberals rail against the Bush tax cuts. I really haven't noticed any tax cuts. When you factor in my state and property taxes, and the fact that I can't deduct these on my federal form because of the AMT, my taxes have risen quite a bit. And now that the Democrats control Congress, it's pretty much a sure bet that taxes will not be going lower. Even if the Republicans manage to hold onto the White House, the best we can hope for is a veto of any tax increase. Don't hold your breath for a cut.

So why do stocks keep going up? Investor sentiment has a lot to do with it. That's really all that matters in the short run. Add to that hedge funds using lots of leverage, private equity firms buying public companies, the new merger wave, and all those share repurchases. The demand for stocks is greater than the supply. This may go on for a while, but it won't last over the long term.