Tuesday, May 28, 2013

I Turn Cautious On Stocks - For Now

For most of the last three years, I have been largely positive on the outlook for stocks.

At first my views were a little contrarian.  Most were convinced that stocks would continue the downward slide begun in 2008 (remember Pimco's Bill Gross "Dow 5,000" prediction?).

Clients were understandably gun-shy of adding to stock positions, and several used corporate bonds instead of dividend-paying stocks for income needs. Institutional investors felt more comfortable adding to fixed income holdings, and to alternative investments such as private equity or hedge funds, than to the publicly-traded equity markets.

Now we have come full circle.

No one, it seems, has much doubt that stocks will continue their relentless rise higher.  For example, here's an excerpt from a research piece written by Merrill Lynch's Michael Hartness last week (I have added the highlights):

Feedback from London client marketing:  

.. Not an equity bear in sight. Investors have flipped from "fighting the Fed" to "daring the Fed". Rhetorical bulls may outweigh those actually positioned for upside, but investors have now decided the right strategy is to be max long risk until the Fed dares to take the punch bowl away....

...Justification for equity melt-up seen as (in order of priority): central bank liquidity, lower returns from fixed income and last and least (surprisingly to us) lower commodity prices/inflation expectations. Many questions on why defensives have led the melt-up. Our response: new investors want yield, disinflation favors oligopolistic defensives with pricing power, global macro data has been poor.  

Or the column I posted last week that Ambrose Evans-Pritchard wrote in the London Telegraph (I added emphasis again):

The latest poll of Morgan Stanley's top clients from across the world says it all.
Chief economist Joachim Fels tells us that not a single investor at the bank's Florence forum thought the world economy would rebound with any strength later this year.

Just a quarter expect a return to trend growth. Some 57pc think there will be no escape from the "twilight" conditions afflicting the western world, and 20pc expect an full-blown global recession. That is a remarkably bearish set of views. Yet the same investors are overwhelmingly bullish on stocks and property.

This schizophrenic exuberance seems entirely based on the assumption that QE and central bank largesse will keep the game going, flooding asset markets with liquidity. Indeed, 80pc think the ECB will cut rates again, and half think it will have to swallow its pride and join the QE club in the end.

Four fifths think equities will gallop on upwards over the next year. Complacency is rife. "It became very clear – and many investors were quite explicit about this – that markets are lulled by the lure of liquidity resulting from negative real interest rates and global QE," said Mr Fels


Finally, here's an excerpt from a research piece published by Tim Hayes of Ned Davis Research:

Threatened by the lowest VIX Index readings since 2007, the highest crowd optimism since early 2011, and other signs of excessive complacency, the risk of a global sell-off has high.  It has left equities vulnerable to the kind of hot money selling that took place yesterday in Japan.

Tim goes on to note the very high stock correlations of stock returns that has characterized recent market actions.  Such high correlations, he says, are a sign that the market has become more of a momentum driven market than one being pushed higher by improving fundamentals.

I am not, I should strongly emphasize, changing my longer term bullish stance.  I think there is a very good chance that the S&P 500 reaches at least 1,700 by the end of 2014, if not higher. 

This call is based on an expectation that earnings for the S&P reach $125 or so by the end of next year.  Applying a reason multiple to such earnings makes my forecast based mostly on math, not optimism.

Near term, however, I worry.  Here's what I wrote to a colleague last week:

I am increasingly convinced that people are overstating the importance of the Fed in both the stock and bond markets.  Yes, Fed intervention is obviously a huge factor in the Treasury market, but even intervention on the scale they are undertaking does not fully explain interest rates.

People are buying bonds at ridiculously low rates because the economy is still punk, and deflationary trends are very worrisome. There was an article in the FT earlier this week about how European pension funds are moving even more money in bonds, away from stocks. According to the article, the 1,200 European pension plans surveyed now have only 39% in stocks – the lowest level since Mercer started the survey in 2003. They are scared to death.

Ever since the credit crisis people have hyperventilated about the inflationary impact of Fed policy but so far they have proven to be spectacularly wrong (funny how we never hear about this). You can’t have inflation if there is no demand.

Fiscal policies around the world are restrictive, and companies are sitting on trillions of cash.  Yes, stocks have gone higher, but only slightly higher than in 2000.  On  a real basis, stocks are where they were in 1997.

Like all other stock jockeys, I justify stock purchases based on low bond yields, which is true only so far as it goes.  When bond yields were higher last decade P/E multiples were higher also – correlations are not perfect.  The difference was the level of conviction about the future, and I don’t believe there is too much optimism.

Why will the Fed raise rates?  Inflation is low and falling and unemployment remains too high. Bernanke is well aware of the 1937-38 period, when the Fed tightened prematurely. There have been several times in the 1990’s and 2000’s that the Bank of Japan tried to tighten, and squashed economic recovery.  Look where they are now.

I think stocks move sideways or lower for the next few months, then close higher by year-end. Still, it is possible that we have seen the highs for the year. Way too much complacency, and consensus bullishness. Obviously I hope I am wrong.

I think we will look back at statements like “70/30 is the new 60/40” as a sure sign that the market had peaked.

That said, I still have 1700 or so for the S&P by the end of 2014.