Equity markets have been bullish for almost five years – despite the negative news, fears and uncertainty that have prevailed during this period. Last year, which started with uncertainty, ended as a good year for stock markets overall. The Dow Jones industrial average, for example, had its best annual performance since 1995 (up 27 percent) and the rise in optimism pushed major stock markets to fresh highs at year-end.
In contrast to equities, other markets – such as bonds, precious metals and commodities – have been declining. The bond market had a poor performance last year as concerns the US Federal Reserve would start tapering its “quantitative easing” (QE) programme caused investment-grade bonds to suffer their worst year since 1994. This also represented the second-worst year for investment-grade debt since 1980, the first loss since 1999, and only the third time in 34 years that the asset class finished the year in the red. US treasury yields spiked 78 percent, causing a lot of pain in this market.
Commodity and precious metals markets also experienced a dismal year. For example, gold was down by 28 percent (about 37 percent since its peak), its worst annual decline since 1981. This begs the question whether or not the equity market will follow suit. Indeed, it is at a mature stage in light of historical experience. The median bull market has historically lasted 50 months and on average 67 months (“Bull Markets Since 1871: Duration and Magnitude” by Tobias Carlisle, greenbackd.com).
So has the market already discounted the best ahead and does it risk turning down despite improving economic conditions? Prevailing sentiment suggests otherwise. Since late last year and into the start of this year, optimism towards stocks and the global economy (especially the US) is running high across the board.
The tailwinds put forward for equity markets include the preference for equities over bonds backed by the so-called “great unwind”, with the secular bull market for bonds having ended last year, and the fact that equity valuations are generally not deemed expensive and earnings are expected to grow on the back of an improving economy.
Furthermore, it is argued that liquidity remains abundant and there is still too much cash sitting on the sidelines. Equities are also seen as relatively more attractive than other asset classes, while the wealth effect (rise in stock markets and home prices) engenders rising confidence.
There is an ongoing need for accommodative monetary policies to ensure a virtuous economic growth cycle. Leading economic indicators are pointing up, soft or contained commodity prices underpin economic growth and inflation remains subdued – all implying an accommodating and low interest rate environment for longer, and thus a low cost of capital.
The levels of market optimism and confidence over last year were reflected in the bullish headlines:
- “The probability of a rerun of what happened in the past decade is low. Should we be worried? Not really. This time really is different.” December 29, Bloomberg.
- The market “does not have the characteristics, as far as I’m concerned, of a stock market bubble”. Alan Greenspan, November, Bloomberg TV.
- “In Silicon Valley. Partying like it’s 1999 once more” – November 26, New York Times.
- “The market is hitting new highs every day, and even the sceptics are going for the ride.” November 27, theguardian.com.
- “QE tapering or not, expect markets to rally in 2014: Mark Mobius, Templeton Emerging Markets Group” – December 18, The Economic Times.
And now? With the bears seemingly having gone into hibernation, the bulls are upping their forecasts. Most of the top market and investment strategists expect equities to end higher this year, predicting the Standard & Poor’s 500 index for example to finish higher this year by around 10 percent.
Could the current levels of optimism be a contrarian signal for equity markets? Bulls tend to disagree. Here are some of their major themes:
- Investors must become totally euphoric before the market can turn down.
- The weak recovery is keeping investors from being bullish enough for a top.
- Markets are only due for a correction (about 5 percent to 10 percent) before they resume their uptrend.
- A correction would present a good buying opportunity.
- You should not wait for a correction, because you may miss the boat.
- Economies are through the worst and are on an improving trajectory.
- Tapering won’t hurt the market… as the economy is growing stronger and will soon expand meaningfully.
- Interest rates won’t rise much in all likelihood, and especially given the Fed’s forward guidance.
- If interest rates rise, it won’t jeopardise the equity market rally.
On the flip side, the issues and concerns raised by the bearish camp include:
- Increasing role of debt and leverage: New York Stock Exchange margin debt, for example, registered an all-time high of $423 billion (R5 trillion) in November. That is a 10 percent increase from its 2007 high, and a 52 percent rise from its 2000 high.
- Sentiment and confidence indicators are reaching extreme or near-extreme levels, in contrast to the deep pessimism that prevailed in March 2009 (the onset of bullish equity markets).
- The Fed’s leverage sits at about 73:1 (the average hedge fund is around 2.48:1, according to Bank of America Merrill Lynch’s November survey), that is, the Fed’s stated capital of about $55bn compared with its total assets of about $4 trillion shows the extent of US dollar, and thus credit, creation (in fact a significant amount ended up as excess reserves in the banking system). This illustrates the unprecedented scale of intervention. A continued rise in bond yields will undermine the Fed’s efforts to keep a lid on yields and will risk unravelling what has been achieved thus far. Furthermore, a modest rise in interest rates will sharply deflate the value of the Fed’s assets.
- Towards the end of a bull market, when optimism blooms, most observers tend to dismiss the possibility of an impending crunch, just as in 2000 and 2007.
- Furthermore, investors tend to revise their positive forecasts upward.
- China’s domestic credit since 2008 is up 2.5 times, from $9 trillion to $23 trillion. It has been noted that China’s growth in credit is faster than Japan’s before 1990 and that of the US before 2008, with half that growth in the shadow banking sector.
- China’s reforms could inhibit growth.
- The euro zone risks a relapse into deflationary recession and underlying tensions could surge again.
- There is a possibility of another European sovereign debt and banking crisis in a world where risky leverage is once again mounting in the quest for elusive yield.
- Stock markets have been losing upside momentum; some early indicators are diverging.
- One main reason put forward by precious metals bulls in 2011 for a continued rise in prices was the belief of indefinite Fed QE. But precious metal prices still collapsed (well before tapering started).
- Endless QE – This was one key argument by bond bulls in 2012 why bond yields would not rise. Yields are presently sitting near 18-month highs.
- In both of the above cases, the majority of investors believed a reversal was unlikely as optimism about the trend prevailed. This is what is prevalent in the stock market today.
Many top market pundits have put forward some good arguments for a continued equity market rise. The relative upside case for equities, which underperformed bonds in major developed markets like the US over the last decade, is regarded as a compelling secular tailwind. Add supportive monetary policy with interest rates at low levels and improving economic growth prospects, and you have a cocktail of factors that underpins market optimism. However, it would be prudent not to ignore the cautionary signals or alerts flashed at this stage of the bull market in equities.
The tapering of QE liquidity commenced by the Fed coupled with ongoing deleverage and more restrictive monetary policies in developing economies will not be without market and economic impact. The reality is that these developments reduce global liquidity and with it support for equity markets. Furthermore, reflating economies via QE and creating and maintaining artificial monetary conditions (which some regard as market manipulation) cannot continue indefinitely. Taking the patient (economy, markets) off “life support” or sustenance (QE) eventually may cause withdrawal symptoms at best and a relapse at worst.
Alternatively, if reflationary efforts succeed above expectations and high inflation ensues, the need to normalise interest rates and unwind QE earlier will become pressing. This scenario will also be negative for equity markets.
The extent of prevailing market optimism does not guarantee a lasting equity bull market, nor does a better economy. However, being overly defensive too early could hurt in the interim as growing market confidence and bullishness build their own momentum. But it would be prudent not to ignore the bearish signs surfacing while the market continues on its path. Caution is advised.
* Fabian De Beer is the chief investment officer at Mergence Investment Managers.