"Pop The Corks, She's Going Down, Boys"
Excerpted from Sean Corrigan's The Baleful Stages of Quankocracy,
In equity markets, the great excitement launched by autumn 2012’s 3QE (easing on the part of the Fed, the BOJ, and the PBoC all at once) seems largely to have run its course. Small caps have lost some of their momentum in both absolute and relative terms and the second tech bubble looks suspiciously deflated. As an example of such indices, consider that the Russell 2000 appears to have completed both this smaller pattern by breaking out below its well-defined channel and that it has filled in a nice looking profile from the depths of the post-LEH slump.
Against this, the large caps have not yet suffered any serious reverse, especially the non-financials among them. What neither they – nor their foreign counterparts like the MDAX – have yet done though is a full-bore, clenched-buttock, margin-reducing liquidation, thus keeping the bears hopeful but frustrated as they anxiously watch the VIX and its ilk grinding ever lower and so signalling that nobody really believes that the end might indeed be nigh.
By contrast, these indices’ larger cousins have hardly suffered at all, with the OEX, for instance, lying the merest whisker away from the previous grand climax set in early 2000. For its part, the S&P ex-Financials has once again undergone a run of around five years’ extent – much as between 1995-00 and 2002-07 – making new highs in the process. If the creation of an almost exact replica of the great tech bubble would now take a final, unlikely looking surge of 25% in the space of the next few months, the 175% gains made so far from the GFC lows are nonetheless hardly to be sneezed at.
Whatever the controversy over how overpriced stocks may or may not be, one key factor undeniably keeps them bid: the fact that bond yields are indisputably too depressed whether one looks at nominals, ex-post reals, current and implied TIPs, or credit. Even EM bonds have unwound all bar the last 25bps or so of their ~125bps ‘taper tantrum’ widening while swaption vols are not far short of their lowest since the 2008 debacle [likewise stock vols and the forex equivalent: what price risk?].
Using our methodology of solving for the implied real trend earnings growth which would reconcile stock P/Es with BAA and/or junk yields, it should come as no surprise to find that US equities are still as cheap as they have been this past three decades, likewise to the current rate of economic growth. Moreover, in terms of carry, from a 55-year median give-up of 250 bps to the 3- month T-Bill, dividends now offer close to 200 bps of premium.
While it is not strictly true that while this relationship holds, stocks must remain supported on the oft-repeated basis that ‘the money has to go somewhere’ (for this forgets that an awful lot of said ‘money’ has been borrowed into existence solely for the purpose of making a purchase and will therefore evaporate just as readily once the target is asset is sold), it does nonetheless mean that until something serves to shatter the currently widespread sense of idle complacency, few will find it attractive to quit equities for fixed income.
Of course, what that does imply is that when the skies finally do begin to darken, the winds could rapidly wind themselves up into an F5-scale twister. Low and declining volatility, lengthening durations, compressed spreads, high multiples, little FX movement – each feeding on the other – is it too far beyond the bounds of reason to suggest that once that virtuous cycle reaches its culmination, the torsional forces involved in its unwind could be remarkably violent?
If we suppose this pretty picture of a fresh cyclical high being set somewhere in the next 15-20% and 6-12 months were to eventuate, the next piece of serendipity would be for the subsequent decline to stretch once more to around 50%, something which might just serve to cut P/Es to something approaching single digits (bravely assuming this all happens without any accompanying earnings collapse) and hence to what would presumably be an attractive entry point at last.
What we can also see is that, starting from the beginning of the overall bubble era at the beginning of 1995, on each of the previous two occasions that stocks have corrected, their returns have converged to those of the bonds they had so distantly left behind during the upswing and, furthermore, that, at that point, returns relative to commodities also touched once more.
Bonds (here taken as the Barclays Aggregate US index) tend to rise at around the 6% pace which has long characterized the nominal growth of money supply and hence the dollar value of those non-monetary magnitudes which one might suspect that latter would influence in the US. So, taking these tentative parameters to the conclusion which they seem to demand, bonds could continue to drift onward for the next twelve months or so, stocks - perhaps with one final hurrah in the interim - might fall heavily as the cycle turns once more.
Commodities, under this scenario, might somewhat counter-intuitively persist with the present move away from recent lows, perhaps recovering to somewhere between their 2011 and 2006 peaks, roughly 15% above here on our DCI © index. Such a confluence - particularly one which might involve the long-awaited breakout of the USD TWI – could conceivably result from a real or threatened supply disruption, perhaps the result of the rumbling international tensions we have discussed.
Recall that, at each of the previous equity highs, commodities managed a counterpoint move of 32% and 42%, lasting respectively 11 and nine months before they, too, rolled over into the ensuing slump. The outperformance, you will note, stretched to 55% and then 84% in those two periods. Who, knows, but perhaps something similar will occur once more when the current mania for stocks at last exhausts itself.
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