I’ve spent considerable time synthesizing all of the information I’ve consumed since the beginning of January, and enough has changed for me to render a new, timely, cogent market opinion. The following signals-through-the-noise attempt to substantiate an objective, data-driven narrative that can guide me through the equity market over the coming days, weeks, months, and quarter…
- Pent-up demand (+)
Coming into 2014, we expected strong GDP growth, starting the year as high as 4% & settling into a 3% FY clip, but bad winter weather disrupted economic expansion. As I’ve maintained throughout, per the data, March should exhibit a spike in pent-up demand if we were to return to trend growth, and recent data (e.g. railtraffic & PMIs) have started to affirm that deduction.
- Global expansion (+)
While growth outlooks are as lopsided as ever with Asia dipping into contraction, global PMI hit a 3-year high in February’s most recent report.
- Household releveraging (PUSH)
5 years after the credit crisis, US household deleveraging seems to have bottomed with 2 consecutive quarters of debt increases and healthy consumer balance sheets starting a releveraging trend.
- Counterpoint: On net, private sector credit may not materially releverage, since corporations seem to have engorged themselves on corporate debt during ZIRP, with their mean reversion likely offsetting any expansion in individuals’ balance sheets.
- Strategists’ sentiment (+)
After being the sole bullish gauge of psychology throughout 4q13, BAML’s sell side consensus indicator remains a buy signal @ 54.1% — below both the neutral threshold (<54.5) and the long term average (60.3).
- Retail sentiment (PUSH)
Individual investors’ excessive bullishness at the start of the year has waned in the wake of January/February’s market drawdown:
The bull/bear ratio has mean reverted back down to historical norms; retail asset allocations to stock are above long term averages but at the low-end of prior cyclical bull markets’ ranges; both signals are at worst neutral, at best contrarian bullish.
- Momentum (+)
It sounds like a penetrating glimpse of the obvious, but look at the data:
Buy at alltime highs, because they’re indicative of secular bull markets, and the frequency of alltime closing highs in 2013/14 suggests today’s market is a secular bull that’s just getting started.
- Margin debt (−)
Every data permutation (nominal/real & gross/net) indicates that margin levels remain at extreme, record levels — despite January’s 7%SPX drawdown.
- Counterpoint: For a bull market, retail participation in the stock market has been lax and could take the handoff from overleveraged institutional investors… but it’s unlikely to be a smooth transition.
- Rising rates (−)
Amidst the rising rate regime associated with the QE taper (and now a feared Fed Funds tightening with the end of ZIRP potentially closer than consensus had assumed), earnings yields should rise with any volatile shifts up in the risk free rate.
At best, a risk-on environment should see a compression in the historic arb spread between the SPX E/P ratio (6.35%) and Baa bond yields (5.10%), as bond yields catch-up to earnings yields and eliminate risk’s relative value advantage.
At worst, stocks should revalue, given a thin equity risk premium (ERP).
Empirically, there’s an analogue to 1994′s bond massacre, in which SPX saw significant multiple contraction (ttm PE from 17.6 to 14.7) in a broad revaluation amidst rising base rates. SPX then ended 1q94 -4% after a -10% drawdown, managing to end the full year only -2%.
- Fundamentals (PUSH)
A refresh of my valuation multiple analysis shows Street consensus resuming its annual, habitual walk-of-shame:
Analysts have already walked-down SPX FY14 EPS growth by 30% ytd.
While valuations are fair on a historical basis, FwPEs will have to expand from current 15.7x to almost 17x if market performance will give investors at least 5%byYE14 — and that’s assuming that FY EPS actually hit that lowered-bar for consensus expectations.
- Counterpoint: Secular bull markets never end at fair value; they always ride momentum’s wave and overshoot.
- Credit spreads (PUSH)
High Yield ($HYG) and Investment Grade ($LQD) spreads have been whittled down to almost nothing:
HY absolute spreads at 379bps have reached another new postcrisis low in the 2004-07 and late-1990s range (low ~250bps), but more importantly, relative spreads are still right there at alltime lows.
IG absolute remain at 68bps – their own postcrisis low in the 2004-07 range – but relative have at least floated a bit higher since hitting a alltime record low in 1q13.
Again, tightening credit spreads contributed +9.4% to junk bonds’ performance in 2013 (+3.0% for IG).
- Counterpoint– Again, the deleveraged household sector can now releverage, taking the handoff from an overleveraged corporate sector. At this point in the greater credit cycle, these spread corrections are merely the undulations of a “short term debt cycle” — not the kind of systemic defaults associated with larger credit booms.
- Mean reversion (PUSH)
Despite a lot of debate citing overfitted data, SPX typically mean reverts after big years like 2013. After >25% CY performance, SPX’s subsequent mean return is only 5.47 vs 11.5% historical average, but with an 18.27% standard deviation, we can’t expect 2014 to be the same, since past data shows high variability.
1946 (-11%) may be the best analogue for 2014, given the pattern of preceding annual returns (through 1945), the ending war, and the demographic trough.
I count 4 positives (+), 2 negatives (−), and 5 pushes (PUSH). Quantitatively, that amounts to a bullish advantage. Qualitatively, I think the aggregate data lean even more toward the bull camp for the intermediate term — although there may be hiccups from high-flying, momo Biotechs ($IBB) and Tech 2.0 ($XLK) corrections along the way.
Five years ago, the US economy was supposed to hit escape-velocity in the years 2014/15. It appears GDP growth is returning to the US economy — albeit with predictable moderation that underwhelms early CBO and Fed forecasts. Intuitively, SPX should enjoy nice multiple expansion during economic expansions… However, extraordinary postcrisis monetary policy changed the game. Paired with a prolonged federal deficit and some fiscal stimulus, QE and ZIRP were bridges to literally breach the output gap. Such measures borrow from the future. Although 2012/13 featured substantial fiscal drags, more countercyclical dragging remains as policy normalizes.
That need for a bridge was created by demographic headwinds, as I’ve discussed at length. My target for demographic resurgence was 2017-20, when the baby boom’s ebb would finally be displaced by the baby boom echo’s ascendance. In a bull market, valuations tend to hyper-extrapolate, pulling-forward rosier, longer term factors than are probabilistically significant or feasible. We call that “price compression” — something we’re seeing occur in Biotechnology ($IBB) stocks here today. As demographic tailwinds arrive within the horizon’s boundary, I’m making sure to watch for such cyclical exuberance on a broader scale.
As always, my default setting should be bullish optimism 90% of the time. In a majority of that 10% balance, a mere 10% SPX correction (~5% drawdown for a diversified 60/40 allocation) is peanuts within the big picture context of a bull market.
With that in mind, the trade activity I’ve been reporting since February has our allocation back up to slightly overweight risk, after we reduced to benchmark-weight earlier in the year. The portfolio’s asset allocation is 65/30/5 vs 60/40 benchmark (stocks/bonds/cash), with beta at 0.81 vs 0.76 benchmark, and sigma 0.92 vs 0.61.
While we are overweight equity on an allocation basis, we significantly derisked out fixed income allocation by selling much of the High Yield and all of the Floating Rate positions we’ve enjoyed for 4 years hence. We swapped those holdings for Municipal Bonds ($MUB) in the sweet spot of the curve (i.e. 7-12 year, high coupon kickers for relative value) paired with interest rate hedges.