Equity markets in the United States, with the exception of the sharp correction in February and March, have marched consistently higher since July 2006, breaching record levels. But with a significantly weaker U.S. dollar and slowing economic expansion, the question on the minds of most traders is whether the equity bull market is sustainable or are we approaching the ultimate blow-off top?
“If you look at a long-term chart, the momentum is still upwards,” says Michael J. Zarembski, senior analyst for XpressTrade Inc. “There are only three weeks this year that it paid to be short.”
But is it greed or fear that is driving equities? Michael Kimbarovsky, principal of Advocate Asset Management LLC, says the bull market is being driven more by a lack of supply than by demand. “It’s really supply-based liquidity.” He says that fear of not participating in the bull market has drawn cash into the market. “When you add liquidity to any scenario, it’s like adding pure oxygen to a fire. Everything will go up,” Kimbarovsky says. “The question is: how much is left?”
BULL SPEAK
“I can’t find any good reasons to be a bear,” says Jason Leander, vice president at Rothschild Investment Corporation. He attributes the strength in equities to three factors: money has been plentiful and liquidity has been high; companies have been sitting on cash and using it to buy back shares removing them from circulation; and private equity is purchasing public companies at a premium, taking entire corporations out of circulation. “All these companies have gone private and you realize: Oh, Jeez, CDW is now private, and you won’t be able to buy stock in that company anymore. You used to be able to put your money in and think about retiring, and you are not able to do that anymore.”
Another positive factor for the market is that consumer spending, which accounts for more than 60% of the U.S. economy and is correlated to corporate earnings, has not been affected yet by the correction in the housing market and the wreckage of the subprime lending industry.
“It doesn’t seem to have any effect on the consumer so far; and as we can see, prices are still moving higher,” Zarembski says. “There are other factors at play besides just the U.S. housing market. It is having less effect than it may have in the past.”
Zarembski says that money from non-U.S. sources, especially Asia, has flooded the equities market, that business spending is picking up any slack in consumer spending; and that all of this is happening despite increasing bond yields and with the yield curve at its steepest since October 2005. “Usually that would be a competitor,” Zarembski says. “When you can get 5.25% on a 30-year bond nearly risk free, you would think stocks would pull back a bit to make that risk a little more palatable to investors, but that doesn’t seem to be the case.”
BEAR SPEAK
“The resilience and strength has been amazing. And intraday volatility has been tremendously high,” Kimbarovsky says. But with the S&P up 6.5% year-to-date, compared with energy, which is 16% higher year-to-date, he is less than impressed. “At a macro level, you cannot grow faster than the GDP for any length of time,” he says, and people have not incorporated the weakening economy into their investment decisions. He notes that that the current 6% U.S. account deficit and unbalanced budget are a drag on the economy, which posted an anemic 0.7% gross domestic product (GDP) growth in the first quarter. “There is not a lot of room in the U.S. for consistent growth under this macro-economic environment. I don’t see a lot of continued upward trajectory in the domestic indexes,” Kimbarovsky adds.
He is also leery of an over dependence on consumer spending. “As long as consumer spending is up, which is 60% to 70% of the U.S. economy, it’s fine. But consumer spending based on easily available credit is going to stop.” He says that a liquidity crunch would move the market toward a “more rational allocation of capital,” and he sees a number of potential catalysts: weakness in the real estate market, more subprime and junk bond defaults and a spillover into the high-leverage private-equity market. “When our clients say to us: ‘take out a more aggressive equity position,’ whether that means higher-beta stocks, or higher total equity exposure, we sort of know we are close to a top,” he says. “When clients start pressuring you, we know they are probably pressuring others, and they are fearing that they are not participating in the upside, that’s the point where liquidity starts disappearing.”
George J. Slezak, registered investment advisor and principal of stockindextiming.com, says that since the recession of 2001, the stock market has looked like the 1932 recessionary low, the 1974 recessionary low, and like Japan’s 1992 recessionary low, and that we are at a critical juncture (see “Lost here before,” below). “Look at real estate, we had a bubble and it went too far and now we all pay for it. Look at the Nasdaq in 2000, we went too far and we paid for it. It is symptomatic of the times that every market goes into a bubble-type expansion and then it gets corrected,” Slezak says. Citing the grain complex and the housing market as recent examples, he adds, “Every market is experiencing the bubble blow-out and then the excessive correction; and we are going to experience that in the stock market over the next 12 months. And how we deal with that is critically important in determining whether we have inflation or deflation.” And the factors that will determine direction are interest rates and the U.S. dollar.
FED SPEAK
In late June, the Federal Open Market Committee said that the economy would likely continue expanding at a moderate pace and that while core inflation improved, sustained moderation had not been demonstrated convincingly. In addition, the high level of resource utilization could sustain inflationary pressures. The Fed concluded: “In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.” They left the Fed Funds rate at 5.25%.
“I don’t think Bernanke has the will power or the stamina to get out in front of the market,” Slezak says. “Alan Greenspan was a great chartist. He knew how to study markets and then forecast where they were going and Bernanke doesn’t have that skill. He is a typical economist; he has a difficult time reporting what has already happened.” Slezak expects higher inflation and for hedge funds to bear the brunt. “They have a lot of risk capital and they are going to take the hit on all the mortgages; and the Fed is going to bail everybody out, eventually, through interest rates.”
And an increase in the Fed funds rate wouldn’t necessarily spell the end of the bull run, Leander says, noting that the U.S. economy expanded healthily throughout the quarter-point march up to 5.25%, where the Fed Funds rate has rested for the past year. The conundrum is on the fixed income side, Kimbarovsky says, and he is amazed at the volatility of the yields, especially on the long side. He is baffled by the strong yields on junk bonds. While defaults are low he says that the demand for sub-investment grade credit, considering the meager pay-off, which he says is just 200 basis points higher than Treasuries, is foolish because they are so highly leveraged and illiquid.
Another threat is the rising competitiveness of the euro as a viable reserve currency and strengthening yields in the Euro zone, where the return is currently 4%. “The U.S. is in a Catch-22 and can’t do anything about it as far as raising or lowering its own rate,” Kimbarovsky says.
As non-U.S. economies gather strength and as non-U.S. governments diversify their investments out of U.S. Treasuries, the question of long-term U.S. economic supremacy is uncertain.
“Over the last 20 years, the influence the U.S. economy on the world economy has decreased,” says Kimbarovsky, adding that in addition to having lost many manufacturing jobs, more financial services institutions are based outside the United States due to our more stringent regulatory requirements.
Zarembski says in the past, when U.S. markets would dip, it was expected that Japan’s Nikkei would follow. “Now it seems like everybody is focused on what is happening in Shanghai. If Shanghai is up, there’s a good chance that the S&Ps will be up as well.” But even that may be changing. “We were kind of going hand-in-hand with China early in the year and now we’ve broken off since then. We can’t just look at the situation here in the U.S. It’s really a world economic situation that we have to focus on.”
Slezak is more conservative in his estimations. “China doesn’t matter. If we inflate, they will inflate. If we go into recession/depression, they will go into recession/depression. China follows us completely,” he says. “Their circumstances are really a reflection of our circumstances. Our wages are rising, so their wages are finally rising. So what? But it’s not their inflation that’s driving our inflation. It’s our economy that is driving their economy.”
The other important fundamental is the U.S. dollar, which has been in decline, and therefore driving competition for bond investment. “As the Euro zone raises rates, or maintains a rate that is comparable or even more competitive to the U.S., and now that China has decided it is moving into hard assets rather than Treasuries, there is this vacuum created. I’m exaggerating, but there is a vacuum created as to who buys U.S. Treasuries simply because China has decided to buy hard assets,” Kimbarovsky says.
GUIDANCE
Kimbarovsky is confident in three sectors: energy service providers, telecommunications and healthcare. He says that while the energy service providers are more volatile than vertically integrated conglomerates, such as Exxon Mobil, they have tremendous positive cash flow. Healthcare is a winner based on the aging of America and telecommunications will continue to benefit from the desire for instantaneous information. “We are still very positive on the internationally-diversified traditional large-capitalization and mid-capitalization stocks,” which he says are more immune to the idiosyncrasies of the U.S. consumer. “At the same time, we have a short on the small-capitalization sector, mostly as a result of what we feel is the most interest rate sensitive sector.” While that hasn’t been a winner for him, it has helped mute his portfolio’s volatility.
Leander is especially interested in technology stocks. “I love the companies that are supplying components to the big tech companies. I would be looking for value, people should be playing around the edges; rather than buying the oil companies, buy the drillers and the services providers.”
Zarembski and Slezak say that because of limited supply, small caps are coming back into favor. But should the Fed raise interest rates, small caps would be the first to feel the pain (see “Russell’s reign,” above).
One thing that the analysts do agree on is that the third and fourth quarters will be volatile, and Kimbarovky urges caution, suggesting that you should invest based on fundamentals rather than momentum. “The risk of capital loss is what you should be focused on, not the risk of under performing a bull market. That is not an easy concept to make resonate with clients,” he says adding “It’s harder to make money when you have lost money.”
