By Filip Mardjokic, CFA
In January, I published my outlook for 2013, which argued for continued long positions in risk assets supported not by fundamentals but by lax monetary policy. As of the end of last week, we’ve ridden the ticker tape higher by +17.9% for the S&P 500 Index and high-yield trading below 5%. Naturally, having that many shiny new chips on the table means we need to start questioning when it’s time to fade the rally.
The search for yield has sent many bonds (including high yield) deep into above-par territory. (For high yield, that is especially notable.) Valuation metrics on equities look slightly more reasonable with the S&P trading at 15× forward earnings. Now for a normal market, that would be about middle of the road, but negative earnings guidance suggests the ratio is probably much higher than that. Yet the bulls remain firmly in control of the market because the Fed continues to control the money supply, and as long as it is injecting liquidity, the equity markets will remain the bond markets’ floodplain. I won’t bore you with another chart, but the link between QE and stock market returns is one that is universally acknowledged and has become an integral and powerful pricing tool for equities. Naturally, then, finding the inflection point for QE will mean finding the top for equities. Without QE, the fundamentals simply aren’t there.
But herein lies the rub: Higher asset prices create positive wealth effects, but at the same time, several governors, including Bernanke himself, recognize that their policies are creating asset bubbles. So the Fed is faced with the uncomfortable decision to tolerate asset inflation or stymie growth and employment. In the end, I think the Fed (led by Bernanke and soon by Yellen) will look the other way when it comes to asset bubbles as long as that asset inflation doesn’t make its way into consumer inflation. (The prognosis for inflation is actually quite good: The headline is below core, owing to the deflation happening in the commodity space; personal consumption expenditures, the Fed’s more favored inflation gauge, is hovering at just over 1%.) All that said, the Fed has already started to signal to the market that it is creating “exit strategies” for its bond-buying program as the United States has been making solid strides toward its recovery. Housing is now a positive contributor and in no small way played its part helping households recover all of the net equity lost during the crisis. Perhaps the most critical change, however, is the fact that money multipliers (via home equity and small business lending) are starting to work again. This means the Fed will grow increasingly cautious of all of that excess liquidity in the system.
Now, what’s interesting to me is the “surprise” sell-off in gold this quarter. Part of it can be explained by strong technical selling following the fire sale by Cypress and big money managers (such as Paulson and Soros) trimming their positions. But I think the bullion market is registering something that the equity markets haven’t yet. Gold, like equities, has rallied tremendously over the last few years as an effective defense against the wholesale assault on fiat currencies. As such, the gold market may be one of the best barometers we have on the prognosis for QE. The fact that gold has struggled over the last few months tells me that the prospect for further easing (save for the Bank of Japan) is fading and rightly so; gold has taken a nosedive. The question is, When will equity traders wake up and smell that same wilting rose?
I think it’s important to note that I have not turned universally bearish on equities because the sad fact remains that there are no other real alternatives. But you cannot ignore the implications of Fed policy, the weaker earnings outlook, and the near uninterrupted upward march we’ve seen. All of these suggests to me that we may see more than just a pause in the coming months: After all, something’s gotta give.
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