Many of you may have noticed that the issue of what drives stock market returns has made its way back to feature-article status again, as well it might. One resumé of the arguments appeared recently in the Economist, and noted manager Jeremy Grantham of the investment advisory firm Grantham Mayo also wrote about it in his fourth quarter letter. Stock returns don't correlate very well with GDP growth, nor do they necessarily turn on corporate earnings, nor even on anticipated growth, as one might think.
Indeed, there isn't any magic rule about investing - if there were, it would immediately come to grief from overuse. Valuations matter, in that it's much easier to lose money from very high valuations and profit from very low ones. But the definitions of what constitutes "high" and "low" are in perpetual dispute, complicated by the built-in bias of the asset management industry towards the premise that they are always low - or at least, not too high. Stock prices have also behaved differently under different inflation environments.
The herd never steps in quite the same place when it runs, but there are some tell-tale characteristics about its relative positioning, and I want to review some of those as an aid to your investment process. One feature is the very appearance of those articles about stock valuations when prices are rising, in apparent disregard of relative weakness in the economy or corporate earnings. Their coming does signal that a bull market is in the late stages. My own experience suggests that the cyclical top is within about a year's time, but hasn't yet been reached. It's still a behavioral dynamic, though, and the top could be a few percent away (e.g., the spring of 2007) or many percent away (the spring of 1998).
Another signal is a growing discussion of liquidity. As I wrote on my own blog last week, by the spring of 2007 "liquidity" was the defining term of the day, to the point where I believe it was Barton Biggs who challenged clients to come up with another reason for investing besides that. Liquidity is resurfacing as an argument for staying invested, but hasn't yet reached the omnipresent stage of the spring of six years ago. Again, it's a sign that the rally is long in the tooth, but not whether it's going to live to be very old, or merely old.
Yet another signal is the incipient breakdown of mechanisms thought to be normally functioning, or not vulnerable to ordinary problems. For example, multiple currency crises signaled the impending Russian default and subsequent collapse of Long-Term Capital. That caused a short-lived 1998 stock market crash that was salvaged yet again by the Fed, which had the unfortunate by-product of helping to nurture notions of Fed invincibility and thus prolong the tech bubble (fine for professional traders, incidentally, but bad for Main Street).
The demises of the Drexel Burnham (1990) and Bear Stearns investment banks (2008) also signaled oncoming bear markets, mainly because of what they said about the credit markets being impaired. A question I have been asking myself recently is whether the recent Italian election is another such signal. Obviously the markets once had deep running concerns about the status of Greece, but it seems to have become inured to the situation, despite the growing fractures there and other places such as Cyprus, Portugal and Spain. The market's philosophy in such situations seems to be that whatever doesn't kill us makes us stronger (or more complacent), and I suspect that by now only a genuine malfunction could disrupt belief in the rally. It isn't enough anymore for the probability to be growing.
Note that I said "belief" in the rally, and for me that is indeed the key. Looking back over the last few decades, what unifies the bull and bear markets is the belief in the momentum of either one. That may seem like a tautology, but the larger point is that the studies cited above have made it clear that lower rates of GDP growth or declining rates of corporate earnings do not necessarily disrupt that belief. It has to be short-circuited by unexpected or profound evidence to the contrary.
An essential feature of the last couple of decades is the role of the Fed and other central banks. The days of "the great moderation" and the massive run of the second half of the 1990s gave birth to a generational mysticism about the power of Fed-based investing. It isn't unshakable, clearly, or we wouldn't have had two massive market crashes already this century or a Great Depression in the last one. But it is something of a default playbook. The fact of ZIRP (zero-rate interest policies) certainly enhances its appeal by virtue of the difficulty of making real returns elsewhere. Any growth or profit at all can be enough to keep equity prices rising, so long as the market believes that monetary policy will soon make them rise again.
If central bank policy is the default mantra of the last twenty years or so, it's useful to think about what disrupts the belief in its potency. The most well known answers are deflation, accelerating inflation, and recession. Neither of the former two are present (others can argue about whether the conditions for the latter are being made inevitable). In this country, recession has always sufficed as an antidote, but that is not currently the case with Europe. I would even go so far as to maintain that the real chief case for European equities, largely unspoken, is not one of cheap valuations, but that there is still room for further interest rate cuts.
For the end of the current bull market, then, the mostly likely catalysts are US recession, European fracture, or war, all of which would hurt credit markets. A bear market is unlikely to develop unless and until one of them happen or are plainly on the verge of doing so.
A correction, however, is a different story. Corrections come about for many more reasons, including fears about valuation, fears that the market is too extended in one direction, clear holes in the current narrative (e.g., the economy isn't as strong or as weak as its media image), fears of central bank tightening, fears that the latest trading fad has run dry, fears of the calendar, pestilence, war, and so on.
The case for a spring-time correction in 2013 is predicated upon three of these: 1) prices are technically overextended; 2) the narrative case for the recovery will weaken yet again; 3) the slavish copying in 2013 of the first quarter of 2012 will make traders ready to drop and run, possibly even earlier than last year.
My long-term technical indicators are screaming danger. They equal, or nearly so, peaks from April 2011, spring 2007, early 2004, and the tech bubble. Only the tech bubble escaped a subsequent 10%-plus correction within a couple of months. Some are indeed making the case for another bubble, but I'm not one of them. You may feel differently.
As I said, the narrative about the recovery is going to fracture again. The recent jobs report was not as good as it looked: The retail sector hired about 48,000 fewer people in December 2012 than December 2011, and as a result laid off 48,000 fewer people in February. That translated into a 48,000 year-year improvement in seasonally adjusted hiring. I don't agree. I'm also suspect of the spike in the motion picture industry - did we suddenly hire another 20,000 ushers? In any case, the net change after two months of 2013 is less than 2012, and that's before the sequester.
The retail sales report isn't as good either, but we won't really see it until May. The year-on-year increase in real (unadjusted) sales was only 1.16%. That doesn't account for the extra day, but the 2005/2004 change was 4.5% without one. Extrapolating an extra day gives an estimated year-year change of 4.8%, the weakest February since 2010, with January also the weakest January since that year. The change in ex-auto, ex-gas was only 4.2%, below average for the month.
On the other hand, Easter comes in March this year, and is one of the three times in the year we invariably open our pocketbooks (the other two being Christmas and back-to-school). When the March data comes out in mid-April, it's not likely to show weakness (though a real miss would have very negative consequences on equity prices). The May release of April data is going to be a challenge.
The rolling twelve-month rate of change in wholesale sales declined again for the 16th month in a row, to 4.8%. The last time it moved from above 5% to below that level was January 2009.
The combined import data for December and January (to eliminate the effects of the port strike in California) fell year-on-year. That's a canary with a very high fever, so far as domestic demand is concerned.
All that said, the market really is copying 2012 so far, remarkably so, right down to the February employment report (236K vs 227K) and year-to-date returns. We're on autopilot, and the rule of thumb seems to be stepping in to buy anytime a decline reaches fifty basis points.
Only a geopolitical shock or an unexpected government shutdown at the end of the month is likely to be enough to stop the S&P from reaching and passing its all-time high this month. If you feel bullish about the rest of the spring, ask yourself what the FOMC will say about asset purchases in April if the S&P legs it up to 1650 (+15%). A correction is coming, and is most likely to happen next month or in May. The problem is, you just can't be sure when.