Tues, JAN 14th, 2014
Happy New Year! I has been nearly 12-months since I lasted blogged. 2013 was defined as a year of change for Albion’s website. Now that the site has been completely refreshed, it is our intent to periodically update the blog in 2014, and beyond, with real-time economic, market and investment insight. We hope you find it both informative and entertaining. Cheers!
We are 9 trading days into the year. The S&P 500 is in a state of churn, though on a vector that is slightly lower than the 2013 close. This has provoked many to proclaim a tough year ahead for stocks [citing the “first five days” rule]. While I am not typically one who affords much attention to silly market “rules”, this one has received an undue amount of press. Indeed, it is out there festering within the mouths’ of the pundits, salivating over any whiff of a correction or bear market. OK. You can have your little five day rule, Super Bowl and lipstick indicators, too, but consider this: According to the folks over at Strategas, market internals so far in 2014 are off to a solid start with Low Quality beating High Quality, Cyclicals outperforming Defensives, Small-Caps besting Large-Caps, and High Beta edging out Low Beta. Too, recent price action from the Transportation and Shipping stocks, as well as from Financials, Building Product companies and Industrials augur well for underlying market fundamentals, and act as read-through commentary on the general economy.
A brief note on the short-run technicals, with respect to S&P levels there is some minor resistance near 1850 and support around 1820.
In Europe it’s a similar story as Small-Caps continue to set the market’s pace; Banks seem a bit healthier and recent government bond auctions from Spain, Portugal and Ireland were met with strong demand and thus lower yields [the Spanish 10-year bond clocked in @ 3.75%!]. At the index level, the climate looks promising as credit and sentiment gradually improves and the European Central Bank [ECB] remains in “whatever it takes” uber-dove policy mode. At the sector level, European bank stocks have broken out on sturdy breadth, which may be a good signal for slowly improving risk appetites. Valuations in Europe remain attractive.
Japan is mixed. The weak yen is being driven by extremely loose monetary policy, which should continue through 2014. With the U.S. Federal Reserve now tapering, the BoJ is unquestionably the king of kings among the most accommodating global central banks. This is helping to boost exports and corporate profits. Inflation figures, including key readings of expected inflation, are turning up after nearly two decades trapped in the jaws of deflation [though admittedly, we have seen head-fakes before]. For now, these are all positive items. On the other hand [my apologies to Harry Truman], Japan’s fiscal policy seems to be tightening some, most notably with a scheduled two-tiered increase in the national consumption tax. However, I cannot help but wonder if this looming rise is more of an effort to pull forward some level of aggregate demand ahead of the tax increase thereby further stoking the coals of inflation [and hence prodding evermore consumption]. Of course, growing tax collections, in theory, certainly help the highly-indebted Japanese government achieve better fiscal stability, but so too does higher inflation. The other arrows in Shinzo Abe’s policy quiver – chiefly trade reforms and government spending on infrastructure – lie somewhat dormant for now.
Meanwhile, emerging markets as a whole are still reporting superior rates of economic growth verses the developed world, yet many stock bourses within these economies have performed noticeably worse. Part of this divergence is a reflection of policy challenges — particularly in China, and particularly regarding debt in the system — as well as structural global economic re-balancing in a post-crisis world. The other element in play is U.S. monetary policy, which has been perceived [and rightly so] as less dovish over the past 6 months. The result has been a reversal of steady “hot” money flows out of these markets and back into more stable markets whose growth and return profile has become increasingly more attractive. Those developing economies with large trade deficits [particularly when backing out FDI] and whose reliance on foreign borrowing is highest have the most to lose under this new paradigm of rising U.S. interest rates. In Brazil, preparations for the 2014 World Cup and 2016 Summer Olympics has driven infrastructure spending. But social unrest remains elevated, demand from China [their largest export market] has cooled, and inflation is running too high. Russia and India are facing vastly different, but equally daunting, political and economic hurdles. Elections this year in India, Brazil, Turkey and South Africa, to name a few, will be crucial in establishing the near-term direction of these regions.
Nevertheless, global growth — the summation of the developed and developing world — should be higher in 2014 than 2013. Indeed, about 75% of world GDP [U.S. + Europe + China + Japan] is either stable or picking up.
So, in getting back to U.S. equities …
Talks of another stock market bubble continue to swirl about. And in a post-bubble world where the market continuously reaches new highs, I understand the avidity of those attempting to call the next top. I argue, however, that while indeed absolute price levels of the Dow Jones Industrials and S&P 500 are at record highs [though, the latter is still short of an inflation-adjusted high] underlying valuation of the market – by far the most important gauge – is reasonable on known information [i.e., not cheap and not expensive]. Put differently, absolute price level alone is not a good predictor of future returns. Yet when one looks out into 2014 and into 2015 a sensible argument can be made that we have more room to go as I expect both the corporate profit cycle and macro economy to continue along their expansionary paths. The allure of equities become particularly engaging when paired with the dearth of compelling investment alternatives and against the low inflation and interest rate backdrop. Understanding this key point is important in recognizing our present location on the bull market road map. The core ingredients that determine equity prices — P/Es, inflation and interest rates — remain supportive of the market at current levels.
Moreover, in performing a thorough valuation analysis one must carefully take note of the components that make up the market’s overall position. High-beta stocks, including many cyclical names, are actually trading below their historical P/Es. Meanwhile, more defensive stocks with higher yields – the favored group during periods of macro stress – remain above their long-run P/E averages as they persist in working off this premium now that the Fed is beginning to dial back QE and the economy picks up momentum. To be sure, this type of valuation inversion is not symptomatic of an overheated stock market. Instead it demonstrates a still-restrained risk appetite. There is no excess of excess, broadly speaking. Not in the economy, not in stocks. In fact from my perch many investors currently own stocks with great resentment. They are shareholders with one foot out the door lacking a true sense of conviction. These invested bears, as I prefer to call them, throw off false readings in the widely referenced investor sentiment surveys and will be gone at the first signs of turbulence. This is neither the texture nor tone of bull markets with too much euphoria.
Finally, a study of long-run stock market data tells us that protracted bull markets – those that extend 5 years or more – generally do not end simply because valuations are perceived as stretched. To wit, valuations can stay elevated for a lot longer than people realize. What usually ends the party is a recession, a brawny Fed tightening cycle [no, tapering QE does not qualify] or some black swan event [i.e., exogenous shock]. At present, we don’t see a recession given the economic data, nor do we expect any time soon for the Fed to embark upon a classic tightening of monetary policy by raising the federal funds rate target *though, this would become a risk if we suddenly get money velocity in the economy*. As for black swans, by definition they are events that are completely unknowable so I will not venture a guess as to the likelihood of one swooping down and *goosing the market.
Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200