Global Investor: Why Bears Are Wrong

It was a good year for world equity markets. most major indexes were up in the mid-double digits, and many emerging markets did even better. Some investors (including yours truly) expect this year to be more of the same. So, why are so many pros so cautious about 2007? Legendary investors such as George Soros, Julian Robertson and Jeremy Grantham are downright bearish. Wall Street strategists David Rosenberg of Merrill Lynch and Stephen Roach of Morgan Stanley are all muttering impending gloom and doom. Hedge funds, supposedly the best and the brightest, have kept their net long positions at very moderate levels and have not chased the current rally.

Many of the best economists are no cheerier. Jim Walker, the highly regarded "Austrian school" thinker for CLSA, the Asia-focused brokerage house, looks for growth to slow precipitately in China and America, while much of the rest of the world slips into recession, resulting in substantial earnings disappointments.

Treasury bond yields could fall toward 3 percent, he predicts, and stocks will drop. David Malpass, an economist for Bear Stearns, anticipates just the opposite--sorta. He thinks U.S. growth will pick up, spurring inflation and prompting the Fed to raise rates, sending bond yields up. But that's not a happy recipe for stock prices, either.

Many major pension funds and endowments have lost faith in plain, simple stocks. In the early 1960s, the typical American, European and British financial institution kept two thirds of its assets in high-grade bonds, mortgages and real estate, and one third in equities. This asset allocation derived from the horrendous performance of stocks after 1929, and the solid and far less volatile record of bonds over the same period. It was a catastrophically bad asset allocation as stocks rose and bond prices fell in the years that followed.

Over the next half century those allocations flipped, with equities approaching 75 percent of most portfolios by 2000. Then came the scary bear market of 2000-2003, followed by the rally of the last few years. Still licking their wounds and suffering from acrophobia, the big pension funds and endowments are reducing their equity exposure and plowing money into hedge funds, real estate and commodities. Not surprisingly, these are the asset classes that have done particularly well in the last few years.

We bulls of the financial world, on the other hand, think that the U.S. and European economies might slow this year, but by no means collapse. Japan was a laggard in 2006 (after a strong 2005) but is again showing signs of life. China and India continue to boom. Other emerging economies are healthy and becoming a bigger factor. This combination spells continued moderate growth, mild inflation, steady to lower interest rates and another year of rising earnings. Not boom, not bust, just plain old Goldilocks. Combine this with valuations that are about 10 percent to 20 percent below where they should be, considering the level of interest rates and inflation, and you get an animal that looks more like a bull than a bear.

Yes, the American public remains uneasy. Flows into U.S. mutual funds last year were virtually nonexistent, though money did go to international and emerging-market funds. Lately, stock-market experts have taken to pointing out "canaries," harbingers of doom like the collapse of copper prices or the recent weakness of the Saudi stock market. But I don't believe in canaries, especially of so feeble a feather as these.

The experts have a low opinion of the stock market's collective judgment. Disdain for "the crowd" is embedded in the investment consensus, and it is very fashionable to be a contrarian. If the market has risen, be contrary, sell and take profits. But I would argue stock markets in the long run are canny old things. They've foreseen major turning points going back to the Battle of Britain, Midway and Moscow, and theyre probably more right than the experts now.

When you ponder your investments for 2007, listen to the U.S., German and Chinese stock markets. They are telling you that the world and equities are still OK. If you must be a contrarian, remember that the stock-market judgment is completely contrary to the conventional wisdom--of the experts.

So, let the experts sell their stocks and pour money into hedge funds, real estate, LBO funds, venture capital and commodities--all of which, incidentally, have fees of between 2 and 5 percent of assets. For the rest of us, there's nothing the matter with a package of big blue-chip growth stocks or, even better, an index fund, which costs a 10th of 1 percent a year. And, surprise, you might just get better performance.

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