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The Wisdom of Crowds

By John Tamny

Not satisfied with traditional measures of stock valuation, University of Chicago business-school graduates Rafael Resendes and Daniel Obrycki founded the Applied Finance Group (AFG) in 1995. Resendes and Obrycki created models showing among other things why earnings do not reflect a company's profits, why P/E ratios are poor proxies for company value, and why sales growth is not a leading indicator when it comes to rising stock prices.

Their research led them to what they call an Economic Margin Framework, which corrects the various distortions and flaws that reveal themselves with traditional "As Reported" accounting figures. Incorporating the widely accepted economic principle that competition gradually erodes excess returns over time, Resendes and Obrycki built a market-outperforming valuation metric that has attracted over 175 institutional clients managing over $350 billion in U.S. equities alone from around the world.

Last month, 130 of those clients gathered in Las Vegas for AFG's annual conference. Eager to compile data on the market and political sentiment of the attendees, AFG conducted a poll on everything from where equities will be a year from now to the performance of Fed Chairman Ben Bernanke to who will enter the Oval Office in 2009. If it is possible to divine wisdom from crowds, and in this case seasoned investment professionals, equity investors have reasons to be cautiously optimistic along with Democratic-leaning voters who hope to re-capture the White House.

Around this time last year, the yield on the 10-year T-Bond passed 5 percent. Characterized as a bearish signal at the time, 82 percent of AFG clients saw it as a negative enough development that they did not assume equities would rise over 20 percent (as they did) in the ensuing 12 months.

Moving to the 18 percent who felt markets were poised for a 20 percent increase, market history suggests their optimism was well founded. Indeed, despite an average 10-year yield of 10.6 percent in the '80s, the S&P 500 rallied 236 percent over that decade. In the '90s the S&P rose 317 percent despite the 10-year yield averaging 6.7 percent.

Measured against two decades of impressive investment returns amidst higher rates, it's understandable how investors might ignore the fact that the 10-year yield has once again moved above 5 percent. Treasuries serve many purposes, including as a safe-haven during times of uncertainty. Rising yields might yet again signal a growing risk appetite on the part of investors that foretells more positive returns for equities. Amidst the recent market carnage largely driven by fear that anti-China trade legislation coming out of the Senate is veto proof, the yield on the 10-year has fallen well below 5 percent as investors have moved back to assets deemed riskless.

When asked if they're more or less bullish on equities today, 47 percent said they're less optimistic, 27 percent said they feel the same, while 24 percent are even more bullish now than they were last year. Applied to the S&P 500 for the coming year, 58 percent of the attendees feel stocks have room to run, but that returns will be no greater than 10 percent. Less than a percent think the S&P faces a greater than 10 percent correction, while a quarter of those polled think it will rise over 10 percent during the next twelve months.

For those making allocation decisions, there's a strong consensus that the S&P will handily outperform the Russell 2000 over the next year, with 41 percent holding the view that outperformance will be greater than 5 percent. The S&P is of course a cap-weighted index favoring larger companies, so the sentiment, while mildly bullish, suggests a growing amount of conservatism on the part of investors.

This jibes with a view held by 64 percent of those polled that we will see $80-a-barrel oil before we see the value of a barrel reach $50. While there was an almost unanimous consensus that the economy could withstand $65 oil and $3/gallon gasoline, oil reaching $80/barrel would mostly be a function of the dollar falling further, and investors seeking large-cap safety over the greater uncertainty that resides in the Russell 2000.

Notably, 72 percent of the attendees felt a weaker dollar would be bullish for stocks. At risk of questioning the wisdom of a crowd of investment experts, this is a view that deserves greater analysis. The general view was that a weaker dollar would be bullish for multi-national companies, which could theoretically sell their wares more easily in countries possessing stronger currencies. On its face it makes sense, but with money a veil, dollar profits that are reduced in real terms by a weaker currency may not be all that they're cracked up to be.

Stocks have surely rallied in recent years alongside a weaker dollar, and it's a view held by some that with the dollar in deflationary territory from '97 to 2001, a weaker dollar was necessary to right a debtor/creditor relationship that heavily favored creditors. Still, with the dollar having long past exited deflationary levels, there's a tendency for this writer to side with the 28 percent who see a weaker greenback as bearish. Looked at from a decade-long perspective, the dollar was very weak in the '70s and the S&P returned 16 percent. During the '80s and '90s, two decades in which the dollar mostly rose in value, S&P returns were respectively 236 percent and 317 percent. Inflation erodes the value of equity returns, and raises the real level of taxation on those returns, so this is something that will be interesting to watch.

It will bear watching, particularly considering two-thirds of those polled think a hike in the capital gains rate after the 2008 elections will cause equity prices to decline. The stats are hard to argue with here. Stocks went nowhere in the '70s when the capital-gains rate was 50 percent, and they only began their rally once rates fell with the Steiger Amendment in the late '70s, along with further cuts in the 1980s. The '86 tax reform bill included a hike to 28 percent; a factor that some believe contributed to the 1987 crash. Moving ahead, stocks rallied handsomely when the capital gains rate was returned to 20 percent in 1997, not to mention the 74 percent rally in the S&P since the spring of 2003 when the rate was slashed to 15 percent. Stating the obvious, when investment returns are penalized, there is less investment. The recurring question then is if cap-gains rates don't rise, will a weaker dollar have a similarly penalizing effect on returns?

While there was a split consensus as to whether the Fed will raise or cut rates next, 93 percent in attendance expressed confidence in Fed Chairman Bernanke. This seems to be in concert with the majority view that a weak dollar would be bullish for stocks. Some would argue that the dollar's substantial fall against other currencies and gold since Bernanke took over has suggested broad market skepticism of Greenspan's predecessor, but if stocks continue to rally as they have alongside dollar weakness, the client consensus will perhaps prove well founded.

Nine out of ten attendees said the somewhat weaker housing market will hurt the economy over the next year. While the OFHEO Index continues to show year-over-year gains, it's certainly true that at least as far as GDP goes, a moderation of home prices could impact the latter negatively. Still, there's potentially a silver lining here for equity investors. Adam Smith taught us that home purchases constitute consumption of capital versus general investment that aids entrepreneurs. Measured over thirty years, OFHEO statistics show that booming property markets are frequently bearish for stocks. Indeed, annual home-price appreciation since 2000 has averaged 8.96 percent. Over this timeframe, the S&P 500 has risen 28 percent. On the other hand, annual home-price appreciation averaged 2.9 percent during the 1990s, yet the S&P as previously mentioned rose 317 percent. The housing market also boomed between 1972-74 and 1976-79, yet stocks were down during both periods.

One factor that might explain the rising caution among attendees is that 60 percent think the next president will be a Democrat. With most Democratic candidates on record as saying they'd like to reverse the Bush tax cuts, including those on capital gains, if the majority consensus holds, investors will have a more difficult tax environment to look forward to.

While 20 percent in attendance felt Rudy Giuliani would be the next president, 36 percent said Hillary Clinton will be the one who takes over in 2008. With the latter talking up unsettling concepts such as "shared prosperity" and "returning high-income tax rates to the levels of the '90s," it will be very interesting to watch stocks in the next 18 months. Will they wax and wane depending on Clinton's polling numbers, and if Clinton is comfortably in the lead by next summer, what will investor sentiment among the attendees be like then?

James Surowiecki, author of the 2005 book The Wisdom of Crowds, says "groups are remarkably intelligent, and are often smarter than the smartest people in them." Looking ahead, it will be interesting to see if Surowiecki's thesis holds when it comes to the successful investors who gathered in Las Vegas last month. Their aggregated wisdom seems to suggest that stocks are a buy, but with the policy outlook potentially darkening, investors should watch the polls as much as they do the stock indices.

John Tamny is an editor at RealClearMarkets. He can be reached at jtamny@realclearmarkets.com.

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