Some Thoughts on the Equity Endgame
February 17, 2011
By John R. Taylor, CIO
In the financial markets, the 'new normal' is beginning to look just like the old normal: junk bond spreads are approaching the lows of the last decade, 'covenant lite' deals are back in vogue, equity valuations are sky high, and financial gearing is headed to the stratosphere. Although this bubble-like activity is a sign that those rational men and women who wished to reform and fortify the institutions so critical to global well-being failed, this reversal to the madcap form of the mid-2000's has allowed growth to accelerate toward the levels of the mid-1990's. The recent good news, everywhere outside of the European periphery, seems to be enough to lock the financial cycles into the general form that has dominated since the end of World War II. We had seen the financial wreckage and losses from the events of 2007 and 2008 as too severe to allow this growth cycle to continue. We were wrong — or at least 75% wrong. What makes us still 25% right is that the next recession, coming sooner than most pundits think, will be precipitated without a significant increase in interest rates, which is totally different than any other post-war cycle. Despite decent economic growth and extreme market optimism, this cycle is crippled as the banking and government issues supporting the monetary expansion necessary for GDP growth have either no capital base or no taxing ability and no further deficit spending power.
The world owes Ben Bernanke for this reversion to form. Last summer our leading indicators and cycles pointed to the start of a new financial decline, probably associated with an economic one as well, but the Jackson Hole speech at the end of August stopped that decline dead in its tracks. Late last July, I wrote (The Rally Is Ending, July 29) that the world economies would be entering a new recession in the next few months and they were ill-prepared for this event. As the QE2 strategy, plus the December Obama-Republican agreement to extend the Bush tax cuts, expand unemployment benefits, give tax credits to business, pumped money into the economy and added roughly a quarter trillion dollars to the already bloated government deficit, the economy perked up, not only in the US but everywhere else as well. Now the long-term cycles look to be exactly on track. Commodity prices are climbing, inflation is a troubling factor in many countries, and bottlenecks are appearing. Although it does not look as though the US will raise rates in this economic cycle — the end of QE2 should be enough to do the trick — the endgame is approaching. The government curve beyond the first year or so is being priced for higher rates, (the yen is weakening as a result) raising the hurdle for equity prices, investment projects, and house prices as well. Commodity prices and labor costs have impacted the emerging exporters and will threaten their growth. If this cycle has some similarity with the one in 1994, as we mentioned last week, commodity prices should continue to climb even though the equity market is declining and the bond market is in shambles. Back then gold peaked many months before equities, as it has now, and did not surpass that high for more than 2% years. Because this cycle is now passing so many of the same signposts that the previous ones did, we feel comfortable about the future. Gold peaked in December, but silver and the other commodities won't top this year unless the next recession starts quickly — and aggressively. Equities look as though they will see two tops, just like they did in 2007. The first of them is likely in March with the second in June, but it is not clear which countries will peak when, or what the intermediate months will looks like. The strong commodity markets and continuing QE2 should keep the dollar under pressure into June, except possibly in Europe where the shorter cycles are arguing for a euro high in March. As the Republican House of Representatives and the fiscal gridlock in Washington will keep Bernanke and Obama in check, an extension of equity and economic strength beyond June looks very unlikely.