Friday, May 3, 2013
I had a great visit with a client yesterday. He and I have worked together for many years, and I generally feel that I learn something from him every time we get together.
Naturally, as the markets continue to move to record new highs, much of our discussion talked about the future prospects for stocks.
I have been generally bullish on stocks for the past three years. In 2010 bullish sentiment was scarce, but I gradually began to feel that stocks had reached a major bottom, and were due for a significant rise.
I wrote a piece in September 2010 on Random Glenings (and I also used for my client quarterly letter) that was typical of my thinking at the time.
The title of the piece was "10 Reasons to be Bullish on Common Stocks", and here's an excerpt from what I said:
Perhaps, I thought, there were a number of reasons to be bullish on the stock market, despite the steady drumbeat of negative economic news and my own innate caution....
1. Fed policy remains very accomodative. As this week's Economist notes, recessions are almost always the result of tight monetary policy. Most of the talk in Washington is about more Fed stimulus, not tightening;
2. With exception of the dismal unemployment rate, much of the recent economic data is actually not all that bad. True, GDP growth is has been low relative to other recoveries, but at least it is moving in the right direction;
3. The highly partisan bickering in Washington greatly reduces the chances of a major fiscal policy mistake. Yes, taxes will probably go higher, but it now seems more likely that they will simply revert back to the 2001 levels, prior to the Bush tax cuts;
4. Transportation stocks have continued to move higher, which is typically a bullish signal for the economy and the stock market;
5. Corporate cash levels remain very high, and we have seen a significant pickup in M&A activity. With top line growth muted, it is now almost an announced strategy for many companies to "buy growth" through acquistions;
6. The appetite for corporate bonds has remained strong, with no signs of worries. Even the junk bond market has been robust, and yield spread levels are back to 2007 (i.e. pre-crisis) levels;
7. Sentiment on stocks is ridiculously bearish. Domestic US stock mutual funds have seen large outflows in favor of either bonds or emerging markets. If most managers are bearish, can't most of the "bad news" be already priced into the market?;
8. September is historically the poorest month for stock market returns, yet we have actually had a pretty good up move so far. The fourth quarter, meanwhile, is historically the best;
9. Referring to point 8: volume has been low, and concentrated in just a few stocks, so a number of analysts say that the rally this month means little. On the other hand, historically good moves in stocks rarely begin with explosive volume, so perhaps the current market action is actually positive;
10. For anyone with a time horizon of longer than a few months, it is hard to get excited about investing in either bank CD's or short maturity bonds, with yields of 1% or less.
Yesterday's market action, I thought, was actually pretty encouraging, since both bond and stock prices moved higher together. There's a lot of cash on the sidelines that needs to be invested.
My client agreed with me a few years ago, and his account has grown nicely. Yesterday he agreed with me on my generally positive outlook for stocks.
However, like the smart businessman he is, my client is always thinking about downside risk. The day will surely come, he said, that we will need to reduce equity exposure, even if that time is not now. What factors would make me turn cautious?
As I look at the list above, most of the factors that made me more positive than most on stocks in 2010 remain in place. There is less bearish sentiment today than was true in 2010, but I still get the sense (and survey data agrees) that many pension and endowment funds are underinvested in public equities relative to their benchmarks.
In other words, many advisors seem to be "talking the talk" when it comes to equity investments, but less are "walking the walk".
The one area that I am watching carefully, however, is the credit markets.
Nearly every serious market downturn in the course of my career has been preceded by either a significant upturn in interest rates or tight credit conditions, and I have no reason to doubt that the next significant correction will be caused at least by similar conditions.
However, the European Central Bank (ECB) just cut interest rates again yesterday, and signaled that they are open to a policy of negative interest rates if European economies continue to falter.
Japanese officials, of course, have unleashed a massive stimulus program ("Abenomics") attempting to revive their moribund economy.
And of course our own Federal Reserve is staying the course on their efforts to keep interest rates low. Recent comments from Fed officials reflect a larger concern with low inflation rates, which implies that it is unlikely that we will see any tightening moves from the Fed any time soon.
The credit markets, in other words, are wide open for most qualified borrowers.
So perhaps the Dow at 15,000 is only an interim step to higher prices?