Do fundamentals matter?

David Tice doesn’t see this rally lasting more than six months. Part of me wants to agree with the legendary bear, who founded the Prudent Bear Fund (BEARX). He thinks equities are overvalued, and I couldn’t agree more. Bloomberg:

‘The economy is in really, really bad shape’ Tice said today in an interview with Bloomberg Television. The Federated Prudent Bear Fund that he founded returned 27 percent last year as the S&P 500 plunged 38 percent, the most since 1937. ‘So many people are trying to be optimistic. We’ve gone from oversold to overbought.’

But this irrational rally has legs, and could continue for a year, maybe even a few. Our current leadership seems determined to goose equity markets and sacrifice the dollar. Until the Fed starts contracting the monetary supply (if they ever do), I’m avoiding large short positions. Events over the last six months have caused me to rethink many aspects of US equities. In April I wrote:

Companies with horrific balance sheets are a dime-a-dozen these days. Fundamentals of the economy are bad and getting worse. Seems like a short-seller’s’ paradise, right? Not necessarily. Inflation and bailouts may be the factors that ultimately decide the battle between Bull and Bear.

Being in foreign assets, precious metals, and select equities may prove safer than shorts. The free-market side of me detests this, because US equities are incredibly overpriced. Being short makes a lot of sense, but as Keynes said “the market can stay irrational longer than you can stay solvent“. How ironic that current irrationality is due in part to his disciples.

It’s important to focus on what is likely to happen, taking into account political and economic realities, not what should happen. There’s too much manipulation, Fed-pumping, quant funds, and distortion to make bets based on logic and fundamentals. Not to mention suspicious short-squeezes.

Am I hedging my statements here? In a way. The direction of this market depends on the actions very small group of people. Gotta stay flexible, since we don’t exactly what they will do. What I’ll be watching most is interest rates. If the Fed tightens, that would be a very negative catalyst for US equities.

S&P 500′s Real P/E Ratio: 129

As I have noted multiple times, US equity valuations are ridiculously high. The real P/E of the S&P 500 is currently 129x. Don’t believe me? Check S&P’s site for yourself. Why is this different from P/E numbers you see, like the 20x number used in the Bloomberg piece on Tice? Two reasons:

  1. Changes to accounting rules, allowing banks to sweep losses under the rug (FASB-157-4 in particular).
  2. Increased use of “operating earnings” to hide losses. This is a relatively new phenomenon. See chart below and this post for a detailed rundown. The MSM and analysts use these “operating earnings” in their bull-cases, despite the fact that they don’t conform to Generally Accepted Accounting Principles (GAAP).

operating-vs-reported-earnings

I don’t like this contrived rally any more than Mr. Tice. But I’m not nearly as confident in a major correction as he is. It’s certainly possible. If The Fed starts tightening, for example, it’ll be time to reevaluate. But the existing power structure will do everything possible to keep the party going.

Note: Prudent Bear is arguably the best long-short mutual fund out there. They maintain long positions in cheap stocks and gold miners to hedge against inflation, smoothing returns. Since January of 2000 (as far back as Google Finance goes) the fund has returned 49% compared to the S&P 500′s -25%.

Related:
Flaws in the Deflation Case (June 22nd 2009)
David Tice Interview with Bloomberg TV (Sept 22nd 2009)

Updated 9/23/09 for clarification

Disclosure: No position in any companies or funds mentioned. Nothing posted here should be considered investment advice. Always consult a professional when making investment decisions.