Enjoy It While It Lasts

"If my timing is correct, and if my macroeconomic assessment is correct," says Ritholtz, "there will be a rally from June through November. That period — that five-month period — will encompass a significant rally. Historically, the last rally of a bull market tends to be the strongest within the cycle."

Ritholtz bases his assessment on a number of factors including trends in inflation and long-term Treasury yields, investor sentiment and the limits of the federal government's ability to stimulate the economy. As for the latter, following aggressive campaigns to cut taxes and hike rates, he feels the White House and the Federal Reserve have all but exhausted their options for sparking economic growth.

Which leads us to the bad news. If Ritholtz is right and this is, indeed, the last leg of this bull market, then next year is shaping up to be an ugly period for equities.

"I suspect the present rally will run longer and further than many expect," he says, "but I also think that the potential downside into 2006 is quite substantial. I don't want to put a number on it, but it could surprise people a great deal."

SmartMoney.com asked Ritholtz how individual investors can profit from the current bull market. While he wouldn't commit to long-term picks, considering his bearish view for 2006 and 2007, he did suggest three exchange-traded funds that would fit nicely into a short-term trading strategy.

SmartMoney.com: You turned bearish at the end of March, and then shifted bullish about two weeks ago. Why did you change your position?

Barry Ritholtz: Around March 29-30 we had a bear call. The internals of the market decayed and the money supply had dropped off enough that we thought it made sense to sell stocks, and look for a better entry lower. We didn't go as low as I had hoped. We saw the market drop from 10800 to 10000. The Nasdaq gave up 100-plus points, the S&P pulled back. I would still like to see a firmer bottom being made. That said, at some point over the next month or so, I think we'll see our most tradable low in the major indexes, which will signal the start of one of the strongest rallies of this post-bubble period. If my timing is correct, and if my macroeconomic assessment is correct...there will be a rally from June through November. That period — that five-month period — will encompass a significant rally. Historically, the last rally of a bull market tends to be the strongest within the cycle.

SM: What indicators are telling you that a market top is coming?

BR: I have a philosophical approach. I believe in something called variant perception. I don't believe the market is perfectly efficient. It's not nearly as efficient as people think it is. If you could figure out where the masses of investors are getting it wrong, there's money to be made in those circumstances. What makes it so challenging to do well is that being right is not much to do with making money. You have to not only find out where the crowd is wrong and where their perception is varying from reality, but figure out how long it will take to come back into focus, to come back to reality.

The housing bubble is a good example of this. The whole world is insisting there's a housing bubble. If you forget everything you've heard, and think about the classic definition of a bubble, the factors don't really exist. In 1999, 90% of stocks purchased were held for less than a year. The National Association of Realtors just did a study that said that less than 3% of houses were sold within a year.... I think we have a bubble in bubbles. That's what I assume is going on now. People who missed the bubble in dot com, in tech, all of a sudden, don't want to get embarrassed. They're seeing bubbles everywhere they look. We're all guilty of it.

SM: How does inflation play into your outlook?

BR: No matter what measure you use for inflation — commodities, wood pulp, cement, when you look at the price of food and health care — there has been a big increase in prices. Automobile prices have gone up significantly.... Yet I continue to hear people look at various data points, and look at it like Candide, and say that everything is the best of all possible worlds.

On the inflation side, the 30-year bond "conundrum," as Greenspan called it, has nothing to do with inflation the Fed can do something about. It's too few dollars chasing too many goods. We clearly don't have wage inflation. The Fed is relatively powerless to do anything about inflation. They're trying to do something about the housing bubble. If anyone thinks that housing will pull back 80% like the Nasdaq did, then we'll be living in a hefty recession. I don't think that's going to happen. Inflation looks low, but really isn't low.

SM: So what do you think this increasing level of inflation portends for the economy?

BR: Would the 10-year [Treasury] note drop below 4% if everybody is really anticipating robust growth? My theory is that the 10-year is below 4% because (a) Asia is exporting deflation. We have inflationary issues on the commodities side; and (b) there's a lack of supply of the 30-year bond... I read this as anticipation by the bond market of a slowdown. Call it a flight to quality. The bond market is actually looking for a weakening. Also China and Japan — the trade deficit is so huge, they're buying tons of securities. How can people say there's no inflation? Everything we buy costs more than it used to.

Growth is more anemic and inflation is worse than people realize. The way that that will become an investing thesis is when it dawns on people that this economy isn't that hot. The variant perception is to see what people believe. The market goes down when there are more sellers than buyers. Anticipating the reversal of that — when there are more buyers than sellers — is the key to making money.