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The following is a guest post by a buy-side analyst working in a US asset management firm:
“…the big money was not in the individual fluctuations but in the main movements, in sizing up the entire market and its trend…nobody can catch all the fluctuations. In a bull market your game is to buy and hold until you believe that the bull market is near its end.” Jesse Livermore
These observations were made nearly a century ago, yet they are as relevant today as they were then. In adopting Mr. Livermore’s approach and “sizing up the entire market and its trend,‟ I still believe we are in a bull market. As such, our game should be to “buy and hold until (we) believe that the bull market is near its end.‟ Furthermore, we must accept that we cannot “catch all the fluctuations” the most recent of these being the ~17% stock market dip over the summer months. That corrective phase has at least paused and is, in my view, entirely behind us. As JP Morgan’s Jan Loeys put it, the subsequent global rally in September was not built on signs “that the world economy improved. It did not. The good news was simply that the economy stopped getting worse.‟
It is true that over the last several months the supporting arguments have shifted, while the general conclusion of being positive on equities has remained unaffected (thereby risking the label of perma-bull). Regardless, this stance is currently built on four core conditions:
- Loose monetary policy
- Attractive valuations
- Pessimistic sentiment and positioning
This piece discusses, in turn, each of the supporting arguments to the bullish thesis and closes with a synopsis of the risks. Lastly, in an attempt to clarify exactly what an outlook
means for asset allocation purposes, I introduce a Model Portfolio Allocation. The current positive outlook on stocks is expressed in a tactical overweight of equities versus bonds.
Loose Monetary Policy
The pressure on central banks to tighten earlier in the year has been replaced by exactly the opposite: pressure to ease further. This shift in sentiment from a tightening bias toward loosening was driven by poor economic data over the summer months. Beginning with Bernanke’s speech in Jackson Hole on August 27th and continuing through September, the Fed made it rather clear they are willing to step in and reflate the economy in order to avoid a double dip. One interpretation of Fed Policy comes from Bloomberg’s Rich Yamarone:
During the September 21st meeting of the FOMC, the Fed said, “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.” This is Fed speak for “We are closer to deflation than any other time in post World War II history, and we aren’t going to let it happen under our watch.”
Since it is impossible to go below zero percent on short term rates, the Fed “eases‟ by adding more Quantitative Easing (QE) or as they now call it, Large Scale Asset Purchases (LSAPs). This diagram from Bloomberg, which displays the three ways the Fed is encouraging risk taking behavior of market participants, appears more relevant than ever. In other words, they are pushing investors (kicking and screaming) to move further out on the risk spectrum; out of treasuries and into high yield credit or equities. Irrespective of whether their efforts will be successful, a first order effect of this commitment toward reflation is a risk asset rally. Thus, (ultra) loose monetary policy remains the number one reason to be bullish on stocks.
There are several ways to approach valuation, most of which are pointing to a stock market that is trading at attractive absolute and relative valuations. As discussed in the
Q2 outlook and shown in this equation below, the current market price is made up of two components: 1) the PV of trailing 12 month EPS into perpetuity and 2) the PV of earnings growth.
Currently, the market is pricing in negative earnings growth for the S&P 500 because the present value of current earnings is 15% greater than the current value of the S&P 500! See the chart below from Citi.
Looking at equities relative to bonds, the S&P 500 earnings yield is currently 6.6% while ten year BB yields are trading at 6.76%. (BB is the second highest notch of “non-investment grade‟ bonds) This is rather unusual and speaks to the “cheap‟ relative value of stocks versus bonds.
Concurring with this assessment are recent comments from Warren Buffet on CNBC, “It’s quite clear stocks are cheaper than bonds. I can’t imagine anybody having bonds in
their portfolio when they can own equities, a diversified group of equities.”
In stark contrast to the aggregate over-leveraged balance sheet of the American consumer, corporate America sits on a conservative, cash rich balance sheet. What’ss a corporation to do? There are really only a few options for a corporation with excess cash on the balance sheet: do nothing, invest (capital expenditures or hiring), acquire, or return to shareholders (dividends or buybacks). Corporations are doing and will continue to do all of these things with their cash. The option that is increasingly attractive and probably has the largest impact on equities is share repurchases.
De-equitization isn’t just about companies using excess cash to buy back shares, it also occurs when companies issue debt for share repurchases. Contrasting corporate America
once again with the American consumer, we see that corporations, on the whole, have access to plentiful and cheap credit. In many cases, it is profitable for a company to access the credit markets to sell expensive debt and use the proceeds to buy back less expensive equity. In doing this they are realigning their capital structure, lowering their Weighted Average Cost of Capital (WACC), and instantly boosting ROE (by decreasing the denominator more than the numerator in the equation: Net Income/Equity).
De-equitization is the general idea of corporate balance sheets being a large incremental buyer of equities. Given the benefits of the strategy and the current position of corporate balance sheets, it seems likely that this trend will resume after pausing in 2009. Such a development would provide additional support to stock prices.
Pessimistic Sentiment & Positioning
July and August saw sentiment indicators hit deeply pessimistic levels. One might expect September’s 8.76% rally to instill confidence, but focusing on measures that indicate what investors are doing, rather than what they may be saying in polls, it appears they continue to view equities with healthy skepticism. When there is persistent doubt in the face of a rising market that is often contrarily positive for equities.
As a general rule, investors in equity mutual funds have the art of timing down to a fine science…Buy high and sell low. Above is a chart of mutual fund flows from ICI, which
indicates that investors are selling their “risky‟ equities and buying “safe‟ bond funds.
Short Interest data from Bloomberg shows that investors have continued to short stocks, even as prices climbed in September. This indicates that investors continue to be skeptical on the durability of the rally and they are positioning accordingly.
The last sentiment measure is the Panic/Euphoria Model from Citi’s strategist, Tobias Levkovich. He does not divulge the exact inputs but taking it from his description as
being a measure of how “investors are positioning themselves‟ (as opposed to what they are saying), it is particularly interesting that this remains in panic territory.
The fact that these measures indicate that investors are bearishly positioned contrasts with several sentiment polls that show investors are optimistic. It is indicative of an
environment where market participants are saying one thing but they are not backing up their words with actions. At such times, it seems rational to put heavier weight on indications of how investors are actually behaving. In other words, talk is cheap.
Anecdotal conversations concur with this lack of belief in a stock market rally. Ask a bearish tilted investor at what point they throw in the towel and cover or move to a neutral allocation: when we hit new highs? When we get to 1,300? My experience has been that they don’t have an answer, which is probably indicative of a high level of confidence in their negative tilt. Perhaps they will be correct, but the fact remains that investors on the whole are rather vulnerable to a rally in stocks and that creates the potential for higher prices leading to still higher prices. George Soros would call this reflexivity, while others might describe it as a momentum driven market. Regardless, markets have a tendency to sniff out vulnerability and punish it. All of this adds up to a market condition of there being more incremental buyers than sellers and that is, on balance, bullish.
One of the largest risks right now is the size and direction of the federal deficit. It is like a giant super tanker heading toward a rocky shore. Some solace comes from the fact that
we have been at worse levels before, albeit, never in peace time. Getting this under control or at least developing some ideas for how to start heading in the right direction
would reduce some anxiety around this looming risk. The bi-partisan National Commission on Fiscal Responsibility and Reform was charged with advising on this topic. The good news is that both democrats and republicans are still at the table. The real test comes on December 1, 2010 when the commission must issue its full report.
If a convincing solution is no proposed or if its implementation seems implausible most investors judge that would negatively impact equities in 2Q or 3Q of next year (Source: CIRA – US Equity Strategy).
Long term inflation
An increase in the Fed‟s balance sheet from higher QE/LSAPs, ultimately increases the risk of an inflation blowout in several years. Also, it raises the perception that the Fed i
monetizing the debt, which decreases demand for treasuries.
According to a survey of Institutional Investors from Citi, the highest ranked current risk is from “Government Policy Missteps” followed by “Protectionism”:
This is how institutional investors view “tail risks‟ from Bank of America Merrill Lynch’s Fund Manager Survey:
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