The bulls are in front – I

Most analysis of trends in individual stock markets tends to suffer from home bias, ignoring signals from the world?s biggest investor. I try to decipher signals emanating from the US and what they mean for world stock markets.

The Indian government is facing a huge fiscal deficit. To bridge this, it will make every effort to bring out a series of PSU disinvestments. Plus, in order to allow a happy mood to prevail on Dalal Street, the withdrawal of stimulus and the hike in interest rates will be much muted. So, the government-sponsored stock rally will gain momentum in 2010.

The latest US unemployment figures indicate a 85,000 drop in December 2009 non-farm payrolls. Higher unemployment in the US will not keep its economy from growing, but it will definitely keep the Fed from raising rates.

Unemployment could lag GDP growth over a period of time, leading to a ?jobless recovery??7 million workers need to be put back to work in the US at the least; so Fed will not be focused on demand-pull and wage-push inflation till then.

Don?t fight the Fed

Martin Zweig, in Winning on Wall Street, argues that investors should not ?fight the Fed?. He discusses the relationship between the discount rate and the US stock market. Most of the time, a rise in the discount rate leads to lower average share prices. A drop in the discount rate leads to higher average share prices. Another concept called ?two tumbles and a jump? indicates that two decreases in the discount rate within a 6-month period lead to an upwards jump in the stock market. On the other hand, one or two rate increases within a 6-month period are moderately bearish for stocks. Three or more rate increases are extremely bearish.

Martin?s point is you should not fight the Fed when it?s intent on moving interest rates either up or down. Given that this is still true in today?s environment, what might take place over the next 6-12 months with interest rates, especially the discount rate?

Whereas the world?s current fundamentals do not justify a sustained bull market in stocks, I do not wish to stand in front of a tsunami of stimulus that continues to be unleashed by different governments. Of the $787 billion in US stimulus passed earlier in 2009, only 22 % has actually been spent. So, we have more stimulus spending coming up in 2010 and this could prop up both retail and institutional spending, making a bullish case for stocks. The Fed?s decision to cut its target rate to 0-0.25% has led to a flush of liquidity around the world, and has contributed to the ongoing stock market rally. This is the lowest the rate has been since 1934.

The Fed has kept rates unchanged for more than 365 days. This is a lengthy period but it?s not without precedent. For the current period to break the 552-day record, the Fed would have to leave rates unchanged through June 22, 2010. It?s extremely unlikely that the Fed will tamper with the rates as mid-term elections are due in the US in November 2010.

I would like to pin my hopes on something called the Zarnowitz rule, which posits that deep recessions are usually followed by rapid rebounds. Since a tremendous amount of activity was put on the backburner over the last few years, we are going to have a lot of pent-up demand coming through.

Amid warnings from doomsayers that the world was headed for a Great Depression, businesses slashed spending more than was justified by economic contraction. Calculations based on Okun?s Law, which links joblessness to output, lead to the conclusion that unemployment should be lower than it currently is.

As the world economy starts growing with the aid of government-sponsored stimuli, companies are going to have to look for ways to expand their business and sales. Typically, companies slash stockpiles after a recession hits because they don?t want to be stuck with products they can?t sell. When demand starts to stabilise, they ramp production back up and rebuild inventories so that they don?t miss out on potential sales and profits.

That?s likely to happen in spades in 2010, history followers say. Through mid-2009, cuts in inventory acted as a drag on the economy for 6 out of 7 quarters?the worst record since the government began keeping score in 1947. In the 3rd quarter, that pattern changed. Inventory cuts waned, allowing the economy to grow. Companies may soon start to rebuild stockpiles. We?re in a sweet spot with regard to inventories.

The recent bear market has been particularly painful for stocks investors, beginning only 5 years after the vicious 2000-02 bear market. For the 10 years ending December, stocks have offered a negative 3.15% real return for US investors, constituting the 4th worse 10-year period since 1871. This led many to question the mantra, ?stocks for the long run?.

A new normal?

Bill Gross, the head of PIMCO, has joined pessimists by claiming the US economy is headed for a ?new normal??slower economic growth and limited stock returns. This prediction is based on lower spending by US consumers who are unwinding from the excess leverage built up over the past decade. The basic notion is that all the new insurmountable problems we now face (deficits, unemployment, exhausted consumers) will keep us in a dismal economy and poor stock market for 10 years. But it seems pretty clear to me that we are now experiencing the same old normal we?ve always seen. I?ve never, ever seen an early bull market without some version of this theme that was widely embraced. Last time around, in 2003-04, it was ?a new era of lower expectations?. Then stocks rose for 4 years.

As a rule, the bigger and scarier bear markets have been, the bigger the floodgates have opened to this sentiment?that new problems are too big and bad to overcome.

It all eerily reminds me of John Templeton?s line that the four most dangerous words in the English language are, ?This time it?s different?. It?s different in details, but the fundamental principles of investing don?t change.

Emerging markets

The predictions of the ?new normal? fail to take into account that it is world economic growth, not just US growth, which will dictate future stock returns. Every dollar of US international indebtedness is matched by a dollar of assets abroad. S&P 500 companies now obtain almost 50% of their revenue outside the US. That share will certainly rise as growth in emerging nations continues to outpace that of the developed world.

Emerging markets account for more than 80% of the world?s population, more than 70% of its land mass and foreign exchange reserves, about half its economic output, yet only 12% of global equity market capitalisation. The latter statistic is an anomaly that will not last. Canny investors should shovel money into the developing world, strap themselves in for the ride and enjoy the fruits of the world?s growth engine.

Emerging markets had 70 companies in the Fortune Global 500 in 2007, up from 20 just a decade back, and are likely to account for a third of the entire list within 10 years. This transition has been impactful. Lenovo, Mittal and Cemex have become household names for their acquisitions of IBM, Arcelor and RMC, respectively. Wipro and Infosys are challenging dominant IT outsourcing providers. Embraer is challenging Boeing and Airbus?s dominance in mission-critical segments. Tata, Reliance, China Mobile and Gazprom are now familiar names and behind them are numerous other companies rearing to announce their arrival on the global stage.

While global population is predicted to reach 8.3 billion by 2030 from 6.7 billion today, only 3% of this growth will occur in the West. The mushrooming of the middle classes in emerging markets is a critical factor. Since 2000, 600 million people have reached middle- class status, spending on average $4 trillion a year and an estimated 70 million people will join the target consumer class annually.

In China and India, it is commonplace for the upwardly mobile to switch high-end cell phones every three months?using an old model suggests ?you are not in sync with the times?. This means these nations will be fertilisation grounds for next-generation multimedia gizmos, networking equipment, and wireless Web services.

Nine futuristic planned communities for 8,00,000 residents each, with generous parks, retail districts, man-made lakes, and nearby college campuses, rise in the suburbs of Shanghai. The once-rundown Pudong district boasts a space-age skyline, some of the world?s biggest industrial zones, dozens of research centres, and a bullet train.

Indians are playing invaluable roles in the global innovation chain. Motorola, (MOT) Hewlett-Packard (HPQ), Cisco Systems (CSCO), and other tech giants now rely on their Indian teams to devise software platforms and dazzling multimedia features for next-generation devices. Tech hubs like Bangalore spawn companies producing their own chip designs, software and pharmaceuticals. Beyond Bangalore, Indian companies are showing a flair for producing high-quality goods and services from $50 air flights and crystal clear 2 cents-a-minute cell phone service to $2,200 cars and cardiac operations by top surgeons at prices, which till recently could be found only at the bottom of the pyramid.

Especially BRICs

Goldman Sachs reckons that since 2007, the BRICs have accounted for 45% of all global growth, compared with 24% between 2000-06 or 16% in the 1990s. It predicts the BRICs will reach parity with the West in just 23 years.

The Conference Board, an international network of leading business figures, believes that the sluggish growth in the established economies of North America, Europe and Japan will result in their share of global GDP shrinking from around half today to a third by 2016. Emerging and developing economies will account for a much larger share of the global pie?as much as two-thirds by 2016.

Research from Goldman Sachs shows that the ratio of equity market capitalisation relative to GDP in the Brazil, Russia, India and China has jumped from about 20% a decade ago to nearer 70% now. In sharp contrast, Western capital markets look mature and the US has already witnessed a lost decade?with stock prices having gone nowhere.

US stocks are cheap compared to forecast earnings. For the S&P 500 index, stocks are now selling for about 14 times projected operating earnings for 2010. Since 1955, stocks have sold at an average 18-20 times earnings when interest rates and inflation are low, just as they are now.

(To be concluded)

The author is a Wharton Business School MBA and CEO, Global Money Investor