Equity markets have been operating in a sort of suspended reality since the equity market bottom hit in March 2009, following the apex of the credit crisis.
The rally in the immediate aftermath of the 2009 low has been an impressive one, technically one of the greatest equity rallies of all time. But no one would confuse the period of the last few years with other bull markets (see “Happy days are here again?” below). The economy has been mired in slow growth with high unemployment since the “great recession” technically ended in June 2009, 18 months after it officially began.
The bull equity market has been fueled by efficiencies born from the refusal of businesses to hire despite strong profits because of general economic and regulatory uncertainty, and driven, most recently, by the open-ended quantitative easing by the Federal Reserve.
In January 2013 the Dow came within shouting distance of its all-time high but did so with historically low volatility and volume. Low volatility, as measured by the CBOE Volatility Index (VIX) can be interpreted as bullish or bearish depending on who you talk to.
Anthony Lazzara, CEO of investment firm Lido Isle Advisors, is bullish equities. He cites the combination of the European crisis drawing down, fears of the fiscal cliff dissipating and the low VIX as reasons. He expects the S&P 500 Index to reach 1550 by June. “It is going to be a stair-step up,” he says.
The VIX has spent most of 2012 in the teens and set a low of 12.30 on Jan. 23. However, Director of Lucas Wave International Jeff Greenblatt, says a depressed VIX is not a positive sign for equities. “The smart money is getting bullish when VIX is at 35 to 40, not now. Markets cannot sustain a rally with the VIX so low.” (See “Leveraging the VIX to spot trend changes,” page 24.)
While a bullish stock market tends to depress the VIX, large moves higher tend to begin with the VIX above 35 (see “Launching pad,” below).
The same can be said of many drivers of the current bull market. Low interest rates and record high corporate profits are signs of a bull market, but markets are forward-looking; at some point rates must go up and companies cannot hoard cash indefinitely.
Buy buy buy
Robert Reynolds, principal of value-based long equity fund Loyola Capital Management, sees strong equity performance in 2013. “The market is going up because stocks are undervalued,” he says. Typically the average price earnings (P/E) ratio for the components of the S&P 500 Index runs 15 to 16 times earnings. In early February, they were between 13 and 14, Reynolds notes, adding that in this low interest rate environment, P/E ratios can rise as high as 20 to 25. “Stocks are significantly undervalued. Related to fixed income, stocks have never been this attractive. Investors have been out of the market, [and]as they move back in there will be huge demand,” he says.
A P/E ratio of 20-25 would translate to the S&P 500 hitting 2160. “I don’t think they will get there,” Reynolds says, “but 18 times is possible, which translates to 1950.” He says a 30% rise in the S&P 500 is possible this year. Yet, he is most bullish on economically sensitive sectors such as auto parts and technology. “We believe the economy will be stronger,” he adds.
Lazzara sees an improving housing market. “This will be a good year for mortgage brokers and construction. Southern California is a hub and everyone I talk to says things are humming along. It will be a good year in housing,” Lazzara says.
Not as bullish is Benjamin Burack, managing director at market-neutral hedge fund Qubit Capital Management. “While relative valuation looks pretty good for the stock market, on an absolute value basis it is not as strong,” he says.
While acknowledging that on a standard P/E ratio the market may look undervalued, by other measures such as Shiller’s P/E, cash yield and Tobin’s q, the market appears overvalued. “It doesn’t mean 2013 will be a bad year,” Burack says, “[but]I don’t see the drivers in place for a new bull market.”
Burack argues that equities have been in a cyclical bull market for four years but in a secular bear market since 2000. That cyclical bull is getting pretty long in the tooth and could be ready to end. Burack says this doesn’t necessarily mean a huge correction. “The market could just stagnate for 12-18 months. It is hard to argue that we are at the beginning of a new secular bull market,” he says.
He points out that at the beginning of the last secular bull market in 1982, interest rates were much higher. “Interest rates were higher and heading lower but in the long run, interest rates [now]can only get higher. Corporate profits are at all-time highs; they may not go down in the next year, but it is hard to see [them] going higher because they are so high right now,” Burack says.
Once again, one analyst’s bull indicator is another’s red flag.
But the question that seems to be dividing the bulls and bears or bulls and more cautious types is defining the market. Some see a screaming bull ready to take out all-time highs and continue to soar, while others see a market that has been relatively flat since 2000 after two bubble-bursting crashes with one additional shoe left to drop.
Burack does not necessarily see another huge leg down on the horizon but says we are still working on the secular bear and points to the Japanese lost decade to show how bear markets can persist for decades and include strong bull moves while still remaining in bear mode (see “The lost decade(s), below).
Whose bull market is it anyway?
While it can be argued whether certain fundamentals are bullish or bearish in the long-term, one point is clear: Equities have been supported by the accommodative policy of the Federal Reserve and no one is sure what the markets will do once the training wheels are removed. Even the staunchest bull acknowledges the Fed’s quantitative easing is behind the current market strength. Will improved economic numbers cause the Fed to pull away, and can the market rally on its own?
Jeff Dean, principal with ITB Capital Management, is bullish in the short run but is not sure there will be clear sailing for the remainder of 2013. “Equities will advance for a short period of time,” he says.
Dean doesn’t expect the Fed to rashly end QE, but improving numbers could cause it to reevalute it in the second half of the year.
“I am not sure the Fed will do anything for a while, [but] a lot of what we are seeing is due to the Fed,” Dean says.
Lazzara agrees. “The one problem could be the Fed stepping back from QE once the economic numbers improve,” he says.
The chances of that may have diminished after the poor, -0.1%, 2012 fourth quarter preliminary GDP numbers. The Jan. 30 Federal Open Markets Committee (FOMC) statement appears to err on the side of continued indefinite purchases: “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability.”
The market’s reaction to the negative GDP numbers also is confusing. The Dow Jones Industrial Average and S&P 500 dropped minimally the day the negative GDP was announced, and both rallied to multi-year highs by Feb. 1, two days later. It appears the market is in a bad-is-good mode because bad economic news will keep Fed purchases rolling along.
Europe: Out of sight, out…
While Dean expects markets to continue higher in the first half of the year based on improving numbers, perhaps even taking out the 2007 highs, he does see a correction in 2013. “I am not 100% sure things are resolved. Europe has not been holding the market down, but is still a risk. They haven’t solved any problems over there,” he says.
Lazzara also predicts a stronger first half in 2013 and sees the end of QE as a potential hiccup for the market in the second half. “It will be a stair-step up, rising to the 1550 area without much of a pullback,” he says. He expects the S&P 500 to rally 10%-15% in 2013 but settle about 8% higher if the Fed retreats in the latter part of the year.
Reynolds expects a minor correction of 5% to 10% at some point in 2013, but sees equity indexes gaining as much as 30%.
The two wildcards mentioned by all are government gridlock on the debt limit or some other governmental dysfunction, and the Fed ending QE. Few analysts expect another debt ceiling fight and most expect the Fed to err on the side of continued QE rather than a premature exit.
Although equity markets appear strong, it seems we are not out of the woods yet. Returning to more normal market drivers — built on real growth rather than Fed stimulation — may include some pain, so traders should be cautious and prepare for one more act in the financial crisis drama.