Are Stocks Cheap? {Part III}

We've been doing a series on whether stocks are cheap based on what we see going forward. You can see part I of this series here. You can see part II a bit lower here  the blog as it was published two days ago.

One thing that ought to be mentioned is that if you are not enamoured of this man pictured above than you had better root against a good economy next year. An economy that is perking along by the summer of 2012 greatly enhances his chances for reelection. By the way the President all but told you that he will be running again when he announced his compromise plan with House Republicans last week on taxes and unemployment compensation.

Then there is the theory of the Presidential Cycle. According to an Article in Forbes Magazine last summer, the theory states:

"{In} Years one and two {of a President's term}, the White House chief executive “fixes” various excesses and inefficiencies of their predecessor. In year one, the new president can blame a downturn of the other guys. Year two gives him the political luxury of taking all blame for whatever continues to drag economic output downward.

By year three, through monetary easing and cheap money, courtesy of the federal reserve chairman (appointed by the president), stimulus kicks into gear. Markets rejoice, voters are pacified, and happy days are here again…just in time for re-election in year four. Every president who has failed to correctly play this four year cycle has not earned a second term." {Story linked above}

If the theory is correct than this is another reason why stocks could rally into 2011. In case you were wondering the market went up in both of the third years of President Bush and President Clinton's terms.

I also wanted to say something about interest rates which have been rising in the past few weeks. It is likely that interest rates will trend higher to some extent in 2011. They have been at such historically low levels that at some point they will be forced up as demand for money grows when the economy begins to move again. Initially this may be seen as a negative. A higher risk free rate of return in government bonds could be seen by some as competition to stocks. Yet I don't think that is how this will be viewed.

First I think that while interest rates rising next year could initially be construed as a negative, I think that ultimately investors will view that as a sign of economic improvement. Since rates are so low this will be seen as an indicator of market health and could have a positive effect on stocks.

Second as of this writing a two year treasury is yielding .62% (62 basis points}. Even if that rate would more than double in the next year to around 1.5%, I still don't see such an anemic rate as competition to stocks.

Finally all that cash on the sidelines in money markets and short term bonds {estimates say maybe up to two trillion dollars!} may be induced by better market conditions and a better economy to look for higher rates of return. In that regard I will refer you to a post I wrote back in February regarding mutual fund money flows. In that post I noted where Treasury yields were back in the 1980s {around 17%} and noted the anemic rates of return investors were receiving at that point for safety. I ended that column this way.

"....this mindless drive by investors to still scramble for yield will likely end poorly as I think stocks should out perform bonds substantially over the next decade. Time will tell but it often pays to lean against the public when they make such a substantive bet with their assets. "

Stocks are up over 12% since the time of that column. Investors in short term bonds are lucky to have made anything at all this year. All that money hiding in little to no yield returning assets could be the kindling to set fire to the markets next year. In that regard I'll republish what Tony Dwyer said a few weeks ago in the shortest research report ever written! "The guys printing the money want you to buy stocks."

Next in this series we'll take a look at some opposing views on what might occur next year.  Then we'll go to the charts to see what money flow analysis can tell us about the year ahead.