Rally for Real? The Negatives

Pat Dorsey: Lets turn to list of negatives. Home inventories are still hot. This is the existing home inventory number that stuck around four million units for quite a while, that's come down to about three million. Still a very high number, still a lot to be worked off, but at least it's moving in the right direction.

Spreads are still very, very high. Although they are coming down, the cost of borrowing is still very high relative to a normal environment. The difficulty that a company may have in borrowing in the credit markets, having to pay a high rate of interest on any bonds that might want to sell in the market, that inhibits what we call capex. That means, it harder for them to fund capital expenditures, which is an economically stimulative activity.

Also on the banking front, again, that LIBOR number I mentioned earlier, is still quite high relative to most of history. Banks are still kind of nervous about each other, and are still charging each other a fairly high rate of interest when they are going into the overnight LIBOR market. And that's a sign that the market maybe a little more nervous on the credit side, than the sort of shiny, happy equity markets we have seen in the past three or four weeks.

Exports are weak now, and they are going to be weak for some time. The rest of the world went into this crisis between six and twelve months after we did, so exports are not going to save our bacon anytime soon. That's going to be a very weak part of the economy for sometime to come. And, it's kind of a double bid, double damage, because exports jobs from the U.S. tend to be very high paying unlike, say the Chinese, who are exporting -ort of low quality goods, low cost goods to the U.S.

You know, we export Caterpillar tractors. We export jet engines. These are companies that have very high paying jobs, they are very high value-added goods, and so if their end markets are very weak, well, that's going to be a weight on the economy for probably some time to come.

The consumer savings rate is still rising. It's at about at 3.8, I think, at last go, and it seems likely to head higher. I mean, it was at nine and 10% levels as recently as the late 80s. And so, "a new age of thrift" is what some people are calling it and again, "the paradox of thrift" what people call it. In the long run, you want consumers to save. You want a healthy consumer balance sheet. In the short run, people increase their saving rate that means they spend less, and that really does dampen economic activity. And the savings rate does look like it's still heading higher.

The Fed's balance sheet is ballooning. We are throwing money at the economic problems that we never had before. We are going to see budget deficits like we've never seen before, and that may very well have pernicious economic effects in the long run: inflation, crowding out of private investment, and other things like that.

And then, finally, to end on my favorite topic valuation. This is kind of a tricky one, because when you look at the prices of some of the highest quality companies we cover our wide economic moat companies, well, they seem pretty cheap. But then you look at the market as a whole.

Right now, the consensus estimate for earnings for the S&P 500, it's about $50 for the whole market, which at, you know, 830 on the S&P means we are trading 17 times earnings. That doesn't seem entirely cheap. But then, again, you would say that hopefully earnings of $50 in 2009, well, that's closer to a trough and closer to a peak.

So, let's go back to more of a peak number in 2006, which was around $85-$90 for the S&P 500. Well, the market seems to be pricing in as kind of getting back to a peakish kind of level, you know, sooner than later.

Maybe that's too optimistic, maybe not. It's very hard to say. But that 'E', that earnings, in the PE equation really is the big question right now, because going forward the economy is very likely to have somewhat higher levels of regulation, somewhat lower levels of leverage.

Banks are being required to hold more capital. The credit markets are unlikely to be as friendly as they were over the past few years. And that's going to mean that your returns on capital probably will come down somewhat. How far do they come down? It's hard to say. That's why it's so difficult to pin a number on it.

Unfortunately, there is no easy answer to: Is this rally for real? But we are seeing, perhaps, more positives than negatives in some time. So, even if we do get some kind of a pull back after having gone virtually straight up for the past month. Again, I think long term, we are seeing the economy healing itself, and we are seeing a lot of high-quality companies trading at pretty reasonable prices.

I am Pat Dorsey, and thanks for watching.

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