May 6, 2003
Some Long-Time Bears Enslaved by Mr. Market

The Fed is unlikely to cut interest rates at today’s FOMC meeting. The Fed’s inaction will not necessarily indicate that the economy is on sure footing and/or that previous rate reductions are finally working their way into the system. On the contrary, the post-Iraq recovery has been timid at best and, at worst, it has been non existent.

While the Fed is not likely to cut rates today, they could bring back their bias.  What this means is that one of the following sentences should be included in today’s statement.

Option # 1: “the risks are weighted mainly toward conditions that may generate economic weakness.”

Option #2: “the risks are balanced…”

Given that Fed futures are pricing in a rate cut by June, and that the post-Iraq rebound has not been as strong as the Fed believed it would be, Greenspan and company may elect to bring back its ‘economic weakness’ bias.  However, if the Fed concludes that bringing backs such a bias could have a negative impact on the financial markets, it may elect to abstain from offering any bias, or opt for option #1.  Enquiring minds will find out at 2:15 PM today...

Bush wants to get more bang for his tax cut buck

If the average dividend yield on stocks was say 6% while the yield on the 10-year Treasury was say 4%, completely axing the dividend tax – the hallmark of Bush’s initial $726 tax proposal – would surely cause a groundswell of capital to rush into stocks. Furthermore, under such a scenario – realizing the likely preference for tax free dividends (at 6%) instead of taxable bonds (at 4%) – the market rally would likely have an outsized impact. For example, if Bush were to simply delegate a set amount of money for tax cuts the impact would be fixed (less any possible trickle down effect). But by eliminating dividend taxes completely the subsequent stock market rally would increase investor confidence (perhaps also consumer confidence a la the wealth effect), and this would more likely (than fixed dollar cuts) lead to the long desired capital spending turnaround.

However, the average yield on stocks is not above that of bonds. Rather, for the month ended April 03 the average dividend yield (on all SIC code rated stocks) was at 2.129% while the yield on the 10-year was 3.86%.


Granted, the gap between stock and bond yields has been narrowing during the bear market - investors are demanding a higher yield to own risky stocks versus safe bonds, and this suggests that the time is right to cut the dividend tax to give stocks a boost. Nevertheless, and as the above chart highlights, dividend yields have been dropping in recent months as bond yields have risen. Could it be that investors are positioning themselves in dividend paying stocks via the mantra ‘buy the rumor sell the news’? 

Will a Reduction in the Dividend Tax Kick off a Stock Market Rally?

As Kudlow notes in one of his latest cheerleading sessions, if Bush’s dividend proposal is passed, “the demand for dividend-paying equity shares would shoot up, corporate de-leveraging out of debt would accelerate, and corporate governance would become more transparent.”

Despite his possibly liquor induced unwavering optimism (Mr. Kudlow conveniently overlooks the fact that he has been wrong about the markets’ direction for the last three years), Larry makes some sense when it comes to discussing dividends.  For certain, given the right dividend tax regulations there would certainly be a ‘disincentive for corporate tax evasion’, and investors would likely move into stocks as opposed to bonds.

However, the ‘right’ dividend tax regulation must also coincide with the ‘right’ investment atmosphere. Quite frankly, at the end of the day stock yields are at historic lows and investors are turning to risk free investments. Thus, igniting a wonderful stock market rally by reducing dividends taxation is a dreamy scenario; one that states what is obvious (tax free is better!), but ignores what is even more obvious: 2% - tax free or not - is simply 2%.

In sum, most Americans are exposed to stocks, company pension plans require stock market gains to remain funded, and enticing foreign capital is a constant in order to fund the current account deficit. So while cutting taxes is passé, cutting the dividends tax could potentially be très chic.  The word ‘potentially’ is worth remembering.

New Bull Market?

In recent weeks some notable market commentators - including Trimtabs’ Biderman and long time bear John Hussman – have turned bullish, or so we have been told. Oddly enough, being bullish these days boils down to a daily or weekly outlook.

In the case of Biderman, he previously stated that “Our definition of a bull market is more money chasing fewer shares.” However, as TheStreet covered yesterday, he now argues that since buyback announcements have waned and insider selling has picked up that his new bull market call is in a holding pattern.

“We have reported many times since last July's initial upturn that after each market rally, corporate buying slowed and selling began. We had hoped this time would be different [but] apparently not. We still think the market is in a bull market...”

As for Hussman, who “increased the equity exposure of his mutual fund from near zero to 72 percent”, he previously noted that since the markets were rising he thought the markets would keep rising. However, he tempered his bullish slant with the statement “it is impossible to form any sort of meaningful forecast even a few weeks or months into the future.” Was Hussman suggesting that now is the time to switch from 0% stocks to 72% stocks, but next week may be the time to move back to 0%? Some enquiring minds may want to know, but the logical long-time bear simply doesn’t care. 

Conclusion

In the case of Biderman, Hussman, and countless others, calls for a new bull market have focused around stock market (trading) strength, not on the contention that companies are fundamentally undervalued. Quite frankly, some bears - not to leave out Biggs who went from being bearish to bullish to head up a hedge fund - have tried to embrace the current stock market rally with the ridiculous caveat that everything could change next week. If the investor cannot buy stocks and forget about their holdings for more than a week what good is any ‘bull market’ call?

While earnings have not been that bad -- Chuck Hill notes, “There have still not been any 1Q03 bombs”, and “analysts so far have shown no signs of slashing 2Q03 or 3Q03 or 4Q03 estimates” – in order for the investor to purchase stocks today they nonetheless have to make a bet that tomorrow’s earnings will be exceptional. Until the economy shows sustained improvement this is a difficult bet to make. For certain, yesterday’s larger than expected layoff announcements (for April) is further evidence that the labor market is weak; that the post-Iraq recovery is no going according to plan.

As for Greenspan and Bush, their actions, or lack thereof, will be in the spotlight today, and the Bidermans’ and Hussmans’ will be sure to comment on what they think this means for the markets tomorrow.  Yesterday the markets were overvalued, if anyone cares…  

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