Are Stocks Poised for Their Next Leg Higher?

I went to go hear Michael Hartnett yesterday.

Michael is the Chief Global Investment Strategist for Merrill Lynch, and I have quoted his work on many occasions on Random Glenings.

One of the reasons I respect Michael's work so much is that he focuses on what actually moves market prices:  fund flows.

As my business school professors used to remind me, the stock market is almost manic depressive.  Some days it is feeling wildly euphoric, while other days it depressed beyond reason.

Stocks in the long run will reflect fundamentals, but managing a stock portfolio has to recognize that fund flows will be a major contributor to investment returns.

Or, to quote investment legend Benjamin Graham, the stock market in the short run is a voting machine, but in the long run it is a weighing machine.

Over the past year Michael has continually noted the apparent distaste that the investment community has had for stocks.  Despite today's low level of interest rates, investors around the world have continued to flee listed equities in favor of bonds.

For example, this was on the CNN website this morning:

U.S. stock mutual funds lost $2.3 billion during the week ended Oct. 10, according to data from the Investment Company Institute. That was far less than the prior week, when investors yanked $10.6 billion. Nonetheless, it still marked the 12th straight week of outflows....

So far this year, U.S. stock mutual funds have bled nearly $105 billion. By comparison, those funds lost around $57 billion during the first nine months of 2010, and $80 billion during the first nine months of 2011.

http://buzz.money.cnn.com/2012/10/18/stocks-bonds-inflow-outflow/

However, despite investor worries, stocks have risen sharply in most parts of the world.

For the 12 months ending September 30, 2012, for example, the S&P 500 has produced a total return of more than +30%. Over the past 3 years, stocks have doubled, and the S&P now stands at roughly the same level in mid-summer 2007.

So what's going on?  How can stocks be moving higher with investor sentiment so sour?

Here's a chart that Hartnett showed yesterday which I though explained alot:

		July
		2007		Today		Change
Central Bank Liquidity		$9.1tn		$20.1tn		119%
Global GDP		$56tn		$70tn		25%
US GDP		$14tn		$15.6tn		12%
G4 Bond Yields		4.30%		1.40%		-2.9ppt
Global bond market cap		$26tn		$47tn		82%
Global equity market cap		$33tn		$29tn		-13%
(free float)
Source:  BofA  Merrill Lynch Global Equity Strategy, Bloomberg, Haver, DataStream

Look at the liquidity that the world's central banks have created. To be sure, this was not done to help stocks, but at least a portion of this has to have flowed in the market. The combination of adding more than $11trillion in funds to global economies, and pushing interest rates down by nearly 300 basis points in the same period, has helped asset prices significantly.

The world's economies, meanwhile, have continued to grow, and global GDP is now 25% higher than it was five years.  Yet the global market equity cap - the total value of all stock markets - is -13% less than it was in 2007.

In other words, while the world frets about fiscal cliffs and euro zone imbalances, the real economy has continued to perk along.

Hartnett believes that stocks have further to run.  While he believes the liquidity-based stock rally is on its last legs, he also thinks that the next stage of the stock rally will occur when bond investors start seeing losses in their portfolios as interest rates rise.

He doesn't ignore that there are risks in the markets - there always are, after all - but believes that once the rotation from bonds to stocks begins, it will provide sufficient fuel to power most global market averages significantly above current levels.