Equities Are Headed Down, but Shorting Isn’t the Answer

 

"Inflation is the senility of democracies."

-- Sylvia Townsend Warner

 

In my last article I observed that, in a poor economy, bear market traps are driven primarily by a collective flawed perception of current and future corporate earnings. I pointed repeatedly to the lagging earnings trends of the 1929 to 1932 correction, as well as to the sheer number of times reckless investors were drawn to deceptively attractive price-to-earnings ratios and high dividend yields, only to see those numbers destroyed by an ever-worsening economy. And that's exactly where we are right now – in the middle of yet another bear market rally driven by faulty earnings and dividend expectations. How do I know this? Because corporations depend on consumers, who have lost almost all ability to borrow money. The spending-spree is inarguably over.

Let me give you a working example of the sort of optimism that might get an investor in trouble. Pfizer (PFE) is a great company – a value investor's dream – sporting a history of consistent and stable earnings, well-managed debt, and strong, albeit relatively similar dividend yields to other strong large-cap stocks. After the crash last November and December, however, Pfizer's dividend yield jumped to over 9%, while it's p/e collapsed! I did all the usual research, salivating profusely, almost completely convinced that Pfizer at a price of $17 per share, was a steal. I took a significant position, and yet a little voice in the back of my mind told me to look deeper, and after doing still more research – which inspired this article, as well as the last one -- I unloaded the position, fortunately at a slight profit. Almost immediately thereafter, Pfizer reported lower earnings, and it slashed its dividend. The stock price tumbled accordingly.

Since writing my last article, I have been inundated with emails asking the same question: in light of my findings, is it time to short equities? And the answer might seem obvious – if earnings are going to fall further, and companies are cutting dividends, wouldn't the best move be to short an index or two? Things, however, are never as simple as they seem. I've said it many times before, but it might surprise you to know I actually believe the stock market is going to go up from here – if only moderately. The reason? Inflation.

From 1929 to 1932, the U.S. government was significantly impaired by the gold-standard, and wasn't able to manipulate the money supply with anything even approaching the current printing spree we're witnessing. As one reader pointed out, the government did re-set the price of gold, in dollars, in the early 1930s, but in real terms that move was so insignificant as to be non-existent -- compared to the $12.8 trillion the government is going to have to print to cover its budget for the next two years (this article should put the magnitude of that sum in perspective for you).

What this means is that a savvy investor could have shorted the market during just about any bear market trap during the 1930s collapse and fared very well – in real terms – because prices were falling as people deleveraged. The specter of inflation was nowhere to be seen. Today, however, although we find ourselves in the same deleveraging environment, inflation is a colossal threat, and it is only a matter of time before prices skyrocket.

This is why I believe the stock market will probably go up a little bit from here, in nominal terms. In real terms, however, I believe the stock market is going to do much worse than even the 90% or so that it lost from '29 to '32, and this makes our current environment so much more dangerous to those uninitiated: it's one thing to see the market falling, and to know how much money is actually being lost. It's quite another thing when the average investor sees the market rising and believes he or she is actually getting rich -- when in fact the losses, in real terms, are staggering.

The truth is, you could short the market here, and even if it goes up, you'll probably make a little money in the end -- after adjusting for inflation. But as I see it there are three problems with this strategy:

1. I have no idea how long it will take for prices to start rising (and neither does anyone else). If my theory is correct, the market will probably hover at current levels for a while.
    
2. Once prices do take off, the stock market will probably rise with them -- although at a slower rate. You'll be left in the uncomfortable position of having to battle the psychology of reverse-mathematics – constantly reminding yourself that even though it looks like you're losing money, you're not. In other words, you'll be short the market, which will start to climb with the rising prices of goods and services -- but at a slower rate. Any short positions will appear to be losers, but since they'll be beating inflation, they'll actually be making money, in real terms. Frankly, that's just confusing as hell, and it certainly doesn't sound pleasant to keep track of.
   
   
3. I still believe in the productivity and innovation that defines many U.S. companies, and eventually they're going to turn around. When they do, I believe their bull run will be as unprecedented as the horror that precedes it. Being short -- no matter how cogent my arguments for the coming storm – means betting against the aforementioned productivity and ingenuity, and that means you'll have to pick the bottom. For my part, I suck at timing markets, and I don't want to have anything to do with trying to find that nadir.
   

I think there are better strategies, including buying gold and oil, and shorting Treasuries. These positions stand to outperform inflationary pressure by a wide margin, and yet offer relatively little downside risk – at least in this environment. Yes, the time will come to offset short Treasuries, as well as to sell gold and oil, but that time is a long way off. I can't say the same for equity markets.

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco will be giving a workshop entitled The Death of the Dollar: How We Can Survive the Coming Collapse at the 21st annual Las Vegas Money Show, Mandalay Bay Resort, Tuesday, May 12, 2009, at 11:30 a.m. He hopes to see you there. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.DisciplineNovel.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.