Richard Russell's Dow Theory Letters turns bullish

San Diego — The U.S. economy is growing at a mere 0.6 percent annual rate, yet the stock market is rolling upward, with occasional setbacks when inflation and interest rates spike up. This seeming anomaly actually makes sense, because stocks today are propelled by financial engineering, not product engineering. Hedge funds and so-called private equity groups are snapping up companies and their stocks. Corporations are manipulating their earnings per share upward by buying back their own stocks, often going into debt to do so. The world is awash in dollars, and many of them are coming back to buy U.S. companies. A money manager doesn't dare sell a stock; some buyout group may suddenly offer to snatch it for 30 to 50 percent above the current price.

Stocks could zoom for the next two or three years -- but then collapse. Liquidity-driven markets crash when the liquidity dries up. Interest rates rise and the bubble bursts, as in the years 2000 and 1929. Tech stocks -- particularly in San Diego -- zoomed to crazy heights in the late 1990s and sold off and are still at half the levels they were seven years ago.

San Diegans have just seen examples of this financial engineering mania. Two buyout groups got into a bidding war for Biosite, a biotech that has been successful (one of the very few). Finally, Biosite sold out for $92.50 a share -- a whopping 66 percent higher than the price was when the pissing contest began. Qualcomm, the highly successful telecom, intends to reduce its shares outstanding by 4 percent as it buys back its own stock.

In early May, Richard Russell, who has been publishing Dow Theory Letters from La Jolla since 1958, turned bullish, proclaiming, "An unprecedented world boom lies ahead." Russell, who turns 83 in July, is often bearish when investors are giddiest. Some say he is a curmudgeon, but his forecasting record is very good. "The boom around the world has not hit the U.S. yet; the public is still wringing its hands about losses in condos," he says. "The money is just endless. Everybody is loaded with dollars." Prosperous countries such as China plunk money in American buyout groups. Foreign companies buy U.S. assets. All this drives up stock prices. Russell admits such spurts can die, but he doesn't see that anytime soon.

"Ride the horse in the direction it's going," says Michael Stolper of Stolper & Co. If he had to choose between a meltdown or its opposite, "I would bet on a meltup." Global liquidity is gushing. Overseas economies are flourishing in sync. The corporate buyouts "will continue to roll as long as banks will finance them -- but at some time the cycle will end. The liquidity will dry up, and there will be a lot fewer players." But that's probably far on the horizon.

E. James Welsh of Carlsbad's Welsh Money Management says that last year, 5 percent of corporate stock was taken off the market through private equity deals and stock buybacks. "This year it's running at twice that rate," he says. So there can be too much money chasing too few stocks -- just what investors believed would lead to a permanent bull market in the late 1990s. That mentality ended with the brutal bear market of 2000-2002.

"We have a new paradigm, centered on what's happening in private equity deals and stock buybacks," says Welsh. "It's great in the short run that companies are buying back their stocks, but they are not putting that money into research and development and investing in ways to make their companies more productive. The seeds of destruction are being sown." Everybody is counting on the Federal Reserve to lower interest rates to keep the buyout boom fueled. But rising inflation could force the Fed to push rates up, not down. The markets could soar for two to four years, "but by 2009, we could have another 2000," he says. Warning: be wary when everybody is bullish, especially when the giddiness is based on financial folderol, not economic fundamentals.