The following is a guest post by a buy-side analyst working in a US asset management firm:
Except for short periods of relief, the last few months have been painful. After extensive deliberation on the question of equity market direction, I continue to be outright bullish. The core causes of the recent selloff are longer term in nature and I believe the climax of hand‐wringing is behind us. Accordingly, I believe the bottom for this correction has been made and the focus of the market will shift back to data on the cyclical recovery. And the most likely scenario is that the cyclical data will resume its previous strength as investors realize that final demand trends and corporate balance sheets are healthy. The scale to the right outlines the core bullish and bearish argument.
At the top of my list of bullish arguments is that cash yields zero and, perhaps more importantly, it will continue to yield zero for long, long time.
At the risk of over simplification, consider the following question: What better time to buy risky assets than when asset reflation is paramount to recovery and the central bank is intent upon encouraging risky behavior?
And consider that in 2009 net new purchases of bond funds reached an unprecedented $350 billion, 16 times the amount invested in bond funds in 2008. In contrast, net cash flows into stock funds totaled under $14 billion. So what happens as those bonds mature and as cash and money markets continue to yield a big donut? Do investors step out on the curve for a bit of yield? Not in any meaningful way. Do they move into corporates? If that hackneyed term, bubble, should be applied anywhere corporate bonds are the most deserving.
As investors are essentially forced to take on risk, I believe the most likely scenario is that flows accelerate into that detested and cursed asset class we call equities. Take on risk now willingly or be forced to buy in later at higher levels. It is time to focus on upside and the reward, rather than the penalty, for assuming equity risk.
As always, we must consider the question: what if we are wrong? This view is most likely wrong under 1,050 on the S&P, at which point I advocate doing something defensive in the portfolios. Specifically, raising cash levels 2-3% and reallocating one position toward defensives. Nonetheless, as I hope to have made clear, I like the risk reward at these levels.
Why the Equity Selloff?
The best answer to the above question appears to be that long term uncertainties are being expressed in current pricing. In other words, the market has shifted focus from shorter term cyclical data to longer term structural economic problems. At first glance that statement may not appear too profound, yet it has frightening implications given that fiscal balance sheets in Developed Markets (DM) are a bloody mess. Obviously, markets are forward looking, but the time horizon usually extends out two or three years. The market is now looking out beyond this horizon and seeing a world of incredible uncertainty. The idea is best expressed by the economists at JP Morgan who build the following logical sequence in trying to pinpoint “what went wrong” and why risk assets have sold off:
Although tempting, one cannot simply assume the first conclusion is true, that the market is mispricing risk. Meaningful price moves must be respected. This leaves us with the original thesis that the market is looking toward the longer term. As additional evidence to the theory, they cite a record wide gap between short- and long-term implied equity volatility. With this shift in focus, the market is collectively asking all sorts of pesky little questions like how are DM governments going to stop and reverse the rise in their debt and what happens to growth if we all tighten fiscal policy at the same time (Is there a country not talking about fiscal tightening?) and how in the world do we bring down structural unemployment. It’s all about the long term right now and data and news on that front need to be the focus. Sustainable growth is the key, which will be signaled by private sector response to ultra loose monetary policy. Lastly, while this is perhaps obvious to most at this point, we must recognize that it is not about Greece per se, but that their problems are our problems and likewise, their solutions (or lack thereof) will be reflected in our markets.
Here is the quick hit list of positives:
- Monetary Policy:
- In two short months all pressure to tighten monetary policy has vanished.
- Central Bank Policy has shown a willingness to stay loose and encourage risk‐taking behavior
- History tells us that the resiliency of the economy in a recovery usually wins these battles. A double‐dip recession is an extremely rare event.
- Euro Banks (BEBANKS Index) have not broken down, in fact they have rallied off support:
- Risk premium is a at a historical high and any moderation here would be positive:
- Valuations are attractive:
- Fading regulatory concerns (Global bank levy did not come to pass at the G20 summit)
- No European apocalypse – while ugly in the periphery the core is still strong and getting better.
- Economic Data out of Germany has been on a tear
- Realization that this dip in the financial markets is not going to feed into the economy
- Bottom‐up sell side analysts are not seeing slowdown in pipelines and channel checks (e.g. Rich Gardner)
- Sentiment levels at or close to panic:
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