"Now times had changed, and the inherited wisdom of the past had become folly."
--Arthur C. Clarke, 2001: A Space Odyssey
We have now ventured into uncharted territory. On Friday, the S&P 500 index exploded higher and closed above 1600 for the first time since the dawn of man. And apparently all because the April employment report came in better than anticipated due largely to a greater than expected increase in mostly lower quality jobs, never mind the steady stream of disappointing economic reports from around the world that preceded it. This epic move marks the latest step in what continues to be a most peculiar evolution in financial markets where interest rates remain bound at zero, where fundamental and technical decision making has been generally neutered, where machines have replaced humans as the driving market force, where good news is good and bad news is even better and where the inherited wisdom of the past has, at least for now, become folly. If only Stanley Kubrick were still around to set this all to film, but alas and alack.
Of course, cosmic price targets often accompany times of market ebullience. The $1,111 price target on Apple (NASDAQ:AAPL) by an analyst at Topeka Securities that was subsequently lowered to $888 is just one many examples of such behavior. But now that we are already in outer space on this liquidity induced trip for the stock market, I suppose it is now time to roll out such quirky price targets for the overall market.
S&P 500 12 to 18 Month Price Target - 2001: A Market Oddity
Why the S&P 500 Index at 2001, you ask? Why not? Given that the S&P 500 Index closed at 1614 on Friday, it would require a +24% return going forward to reach the 2001 mark. Reflecting on the fact that stocks have already advanced by +28% over the last 16 months since the beginning of 2012 not only on pure valuation but also in the midst of forward earnings estimates being reduced by -10% along the way (in other words, the "P" in P/E has skyrocketed at the same time that the "E" in P/E is dissolving), it is certainly more than possible that we could see another +24% advance over the next year and a half as long as we continue to live in a world where investors seek to pay increasingly more for securities that are increasingly worth less.
But what beyond the fact of boundless central bank liquidity is the rational case not only for the move in stocks that we've seen to this point, but also for this advance to continue at the same pace into the future? The continued chase for yield is one likely possibility. The fact that some other major asset classes like High Yield Bonds (NYSEARCA:HYG) are entering into price levels where further upside is becoming increasingly limited is one more.
Another is the equity risk premium, which still looks most attractive by recent historical standards. At present, the equity risk premium relative to 10-Year U.S. Treasury bonds is a healthy 3.43%. To put this figure into historical context, the average equity risk premium based on this metric over the past 50 years covering much of the post WWII debt supercycle has been effectively flat at -0.03%. Moreover, this reading has averaged well below zero at -1.37% over much of the last three decades prior to the outbreak of the financial crisis. Thus, with 10-Year U.S. Treasury yields as low as they are today, significant room exists to the upside for stocks to fill this risk premium gap. For example, a move to 2001 with all else held equal would only lower the equity risk premium to 2.39%. In fact, the S&P 500 would have to rise beyond 15000 to return to its pre crisis average of -1.37% over the past three decades all else held equal. Forget Dow 15000, perhaps it is time to toss out S&P 15000! With the stock market already well on its way to Jupiter at this point (or Saturn's Iapetus if you are more of the literary persuasion), anything is certainly possible.
Of course, a number of highly unstable risk factors stand in the way of the S&P 500 completing such a bold mission higher into uncharted territory.
First, what if today's higher equity risk premium marks the return to the norms that existed prior to the post WWII debt supercycle. If indeed the debt supercycle is coming to an end and a major deleveraging is now upon us in the global economy, current equity risk premiums would appear average at best if not low by historical standards.
Also, what are the unintended consequences of boundless money printing and zero interest rate policy on the global economy and its financial markets? While everything appears to be running smoothly today, at what moment does the market system suddenly go haywire?
In addition, what if the much ballyhooed great rotation from bonds into stocks actually takes place and interest rates begin to revert either by choice or by force to their long-term historical average? This would imply a move higher in the 10-year U.S. Treasury yield from Friday's reading at 1.75% all the way up to 4.65%, if not higher. Not only is this an absolutely gut wrenching move from a convexity standpoint, but it also completely blows apart the valuation thesis for the equity market, as stocks that once appeared attractive will suddenly look extremely expensive. Thus, for those longing for the great rotation from bonds to stocks, be careful for what you wish.
Thus, those entering the stock market under the notion that it is the best place to realize a reasonably attractive rate of return should do so with great caution, for not all else is held equal and any underlying shifts could have dramatic and negative consequences on stock prices.
But perhaps more than any of the above, one risk in particular is arguably the most threatening of all.
The Dangers of Technology
"The 9000 series is the most reliable computer ever made. No 9000 computer has ever made a mistake or distorted information. We are all, by any practical definition of the words, foolproof and incapable of error."
--H.A.L., 2001: A Space Odyssey
Make no mistake. The recent 271 point advance on the S&P 500 since the mid November 2012 lows has not been driven by the likes of you or me or anything carbon based for that matter. After all, domestic equity mutual funds have experienced net outflows of over -$26 billion over this same time period. Instead, this move has come largely as a result of the major institutions, silicon based computers and high frequency trading algorithms that has set daily trading activity ablaze with pockets of extreme volatility.
To this point, we have been told that these HFT programs are fully under control of their masters. Not only do they execute millions of precise quote and trade decisions in a matter of nanoseconds, we are also reassured that they provide markets with much needed liquidity. I suppose they can probably even politely entertain with a rousing game of chess during off market hours. And to this point, it has been all fine and dandy. Until, of course, it is not and investors wake up one day to find the market terminally frozen in a cryogenic state.
We have seen scores of examples over the last several years of the market or individual securities falling wildly and unpredictably at a moments notice, only to just as quickly recover their value and return to normal. But what happens one day when things do not return to normal and continue to break down? Worse yet, what happens the markets unexpectedly come under attack by computers driven by the intent to inflict harm on the global financial system? These are risks that must be taken seriously in today's unpredictable market environment.
A recent quote by Eamon Javers from CNBC regarding the oversight and regulation of high frequency trading summarizes why investors should be particularly concerned about the computers that are dictating the direction of markets on any given trading day:
Part of the problem is that a lot of people just don't fully understand this world. You kind of go down the rabbit's hole here a little bit into a nether world of milliseconds and nanoseconds and people don't understand what's happening at that level. I call them quantum economics and things happen in a very different way at that speed.
If activities are taking place in markets that both investors and regulators are struggling to understand, this alone suggests a higher than normal probability for a major financial accident at some point. This is why it is so important for humans to continue playing their part in the trading function within markets.
Beyond The Infinite
The upside potential of the stock market at this point is boundless. Unfortunately, the downside risk is just as meaningful, if not more so. Thus, an allocation to stocks is certainly warranted, but such positions should be maintained with great care and scrutiny. Emphasizing stocks that exhibit quality, low volatility, value and current income that are also not technically overbought is one way to participate while still controlling against such risks, at least to a degree, in the current environment. This includes allocations such as the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) and high quality individual names such as ExxonMobil (NYSE:XOM), International Business Machines (NYSE:IBM), McDonald's (NYSE:MCD), General Electric (NYSE:GE) and Oracle (NYSE:ORCL).
Knowing the risks associated with being overly dedicated to any single asset class, it is also prudent to hedge stock allocations to protect against the sudden downside shocks that could easily present themselves on any given trading day. This includes positions with low correlations such as the PIMCO Total Return ETF (NYSEARCA:BOND) or the PIMCO Global Advantage Inflation Linked Bond ETF (NYSEARCA:ILB). This also includes allocations that are likely to rally sharply in the event of a stock market shock but can also continue to rise along with the market such as long-term Treasuries (NYSEARCA:TLT) or Build America Bonds (NYSEARCA:BAB). The precious metals complex also continues to offer appeal from a long-term diversification perspective despite their recent challenges, including gold (NYSEARCA:GLD), silver (NYSEARCA:SLV), platinum (NYSEARCA:PPLT) and palladium (NYSEARCA:PALL). While owning the physical remains ideal, for those interested in owning the precious metals in a securities portfolio, the Central GoldTrust (NYSEMKT:GTU), the Central Fund of America (NYSEMKT:CEF), the Sprott Physical Silver Trust (NYSEARCA:PSLV) and the Sprott Physical Platinum and Palladium Trust (NYSEARCA:SPPP) are all quality selections.
It remains to be seen whether this latest market evolution leads us to a pleasant or disastrous ending. I continue to think that in the end it will be the latter, but this could occur tomorrow or several years from now. But more than anything else, it is important to keep in mind that we remain in uncharted territory. While this may ultimately lead us to previously unthinkable heights, it could just as easily send us propelling toward fresh new post crisis lows before its all said and done. For this reason, it remains important to proceed with caution while also seeking to capitalize along the way.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
Disclosure: I am long AAPL, XOM, IBM, GE, MCD, ORCL, VIG, BOND, CEF, GTU, ILB, PSLV, SPPP, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.