Be optimistic, yes, but have insurance

by Stephen Butler

"It's dangerous to make predictions -- especially about the future."

Everyone from Mark Twain to Yogi Berra is given credit for that line. Meanwhile, what a difference a week makes.

Last week, I was just a nattering nabob of negativism with regard to the economic impact of rising interest rates. Searching for good news to lift me out of my funk, I found plenty of offsetting optimism in columns like that of Paul Lim in the New York Times, as well as the informative bulletin from the ubiquitous Ken Fisher. Then, there's always Bob Brinker and Norm Fosbach.

Last week, I pointed out that rising interest rates are bad because corporate bottom lines and consumer spending power both decline. This is bad for both the economy and the stock market.

For the past several years, bond traders and investors have been buying 10-year bonds that paid only 4 percent interest, because they felt that the economy was going to be weak in years to come. With a weak economy, there wouldn't be much of a demand for borrowed money, so interest rates would remain low for at least 10 more years.

As a general rule, bond traders have tended to be the best predictors of future events when compared with economists or stock analysts.

The counterintuitive view is that the robust economy is the reason bond traders now want to dump those bonds paying just 4 percent, because the new rate is 5 percent and rising.

So, the question is this: "Will a robust economy and continually growing corporate revenues be enough to offset the cost of higher interest rates? And, will higher interest rates lead to a slowdown of consumer spending, leading to an economic downturn?"

Now for some "happy talk." Fisher points out that corporate profits have been growing more rapidly than stock prices have been appreciating. If interest rates and corporate profits remain constant, stocks would appreciate by 70 percent before reaching their historical price relationship when compared to bond values.

Another factor, which every optimist cites, is that corporations are buying back their own stock because they think it is underpriced. This increases the value of the stock that is left.

Let's use a simple example: A company worth $1 million and owned by 10 $100,000 investors happens to have $200,000 sitting in cash as a result of two profitable years. If it uses the $200,000 to buy out two of the investors, the remaining stockholders who owned 80 percent now own 100 percent of the same $1 million of value.

This increases the value of investors' shares to $125,000. Across corporate America, this practice has been happening with a vengeance as corporations buy their own publicly traded stock and then retire it to create capital gains for the remaining stockholders.

The dark side of this practice is that it increases values for executives who have been granted stock options, so their motivation may be suspect.

Fisher points out that a bull market feeds on what he would probably term "a superficial aura of pessimism" -- like my column of last week -- while underappreciated positive fundamentals continue to prevail.

The fundamentals he cites are: Stocks are still cheap relative to profits; the global economy is thriving; the world is awash in cash that will keep interest rates low; and corporate buybacks are reducing the supply of available stock.

Moreover, subprime mortgage market worries are overblown, and most of the geopolitical threats have already been "discounted" into the current stock prices. "Discounting" means that the probable impact of a future event already has been reflected in the price for a stock.

For the most part, then, some of the most respected market sages are telling us that the market will continue to rise for the next five years. As a group, they seem to predict that total increases will be as much as 50 percent during that time.

The question I have is: "What if they're wrong?" I like knowing that I have some "insurance" in the form of large value-oriented mutual funds and short-term bond funds. I can pass up some of those possible gains in exchange for a better night's sleep.

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