As we enter the new year of 2014, I would say that prognostications are fundamentally unchanged. Everyone who was bullish still is, and the much smaller group who wasn't still aren't. There are the fingers-crossed bulls, nervous about valuations and the sharp rise of last year; the confident momentum bulls (think Jim Cramer) who are certain that the markets will go up again, regardless of what those effete, sniveling naysayers might squeak; the institutional strategist bulls, who annually make the very useful prediction that markets should be up about 10%, unless everything goes right, in which case they will go up more, or everything goes wrong, in which case they will go up less.
One of the more pronounced investment themes going into 2014 is Europe. The core of the argument is similar to the kind of bottom-feeding you find near the end of any prolonged bull market - as managers run out of ideas that aren't at or past the tops of historical valuation ranges (or just plain reason), money will circulate towards the laggards.
Indeed the Europe thesis, which started gaining currency in the summer, gained considerable steam in mid-December, as new-year investment themes are wont to do. The popular Vanguard European ETF (VGK) was "only" up about 12% for the year at that point, and it rallied nearly 8% through the last two weeks.
This is one of those situations that make me uneasy, first of all because the year-end consensus on where to go the following year usually ends up being dead wrong, especially after a big momentum run. If markets have been soaring, the conversation is always where the next hot sector is and why prices cannot fall more than a few percent; if they are tanking, it's about which mattress is best to stuff your Kruggerands in while loading up on diesel fuel and dried fruit.
Yet nothing has really been fixed in Europe. Yes, no one has decided to test the European Central Bank's (ECB) resolve to backstop sovereign bonds, and that has been a boon for their financial markets, even though the structure of the mechanisms is such that a serious test would likely expose their inadequacy. Such a challenge seems unlikely to arise except in a panic, perhaps, but even so, eurozone finances are still weighed down by Japanese-style bad debts: No one wants to admit to them, so they are rolled over and/or hidden in the hope that time can cure their deficiencies. In the meantime, credit expansion is moribund.
As the BlackRock investment group pointed out in its 2014 prognosis, if Japan, the emerging markets and the eurozone are all trying to export their way out of trouble, it begs the question of who will be the buyers of all of these exports. The growth rate of non-petroleum goods into the U.S. has been steadily falling for many months now and is now barely 2% annually. BlackRock's conclusion is that the math will not work, one that I too reached some time ago. The EU could take a different path by restructuring their debts in a more productive way, but in this area they have been no more capable of action than the U.S. Congress - only a crisis can get them to do anything.
With all of that said, there is still the money river. Indeed, nearly all of the bullish arguments are really founded on a continued surfeit of liquidity, however they may be dressed up in different raiment. The same investment groups will assert in the same outlooks that nifty-fifty type stocks will do well because growth is at a premium, then recommend industrials in a different paragraph because - in a repetition of every annual outlook for the last five years - global growth is about to pick up.
Ironically, global stock markets would only be able to withstand a small pickup in growth. Years ago I heard Allen Sinai declare to a group that stocks were indifferent to GDP. At the time I thought him brash, but with time and study I have come to conclude that while there is a long-term correlation between GDP and stocks, there is little to none in the short and intermediate term. Don't misunderstand me - surprises and trends do matter, but not very long. The modern market runs most of all on liquidity and sentiment.
The money river - or if you prefer a more formal term, return-maximizing investors - will continue to throw money at assets, equities in the front row, until an event or series of events can scare them away. Historically, these events usually originate in the credit markets, with geopolitical mash-ups running second.
The credit markets are frothy now, make no mistake about it, and have been loose for some time, The Chicago Fed's Financial Conditions index has been in the peak zone for months and is near record levels.
The problem from the investing point of view is that the credit markets are almost entirely over-the-counter and transactions and holdings are usually opaque. Optimists are invariably found boasting most of all of no visible catalyst for a tightening of credit conditions just before some storm hits. Even experienced institutional equity portfolio managers are often taken aback at the speed with which the credit market windows can slam shut.
Equity trades are done on exchanges where there are Congressional investigations if market-makers disappear. Not so in bond land , where trading desks in times of high anxiety will simply stop bidding on issues. The price of an IBM bond might not move that much, because of the "matrix" pricing system that bond pricing systems use, but there is one catch - nobody will buy them from you at the stated price. Not at any price, in fact, that isn't complete fire-sale absurdity, and sometimes not even there.
Too much pickup in growth - a problem I don't see happening, though the fear of it well might - will spook the bond markets, and anything that spooks the bond market these days is going to have repercussions in equities, where the margin of error has become thin. More likely in my opinion as a credit market problem is a "Minsky moment," with some supposedly stable credit market sector getting so leveraged up that it implodes from a small breeze of doubt. I should add that such a moment might not originate in the U.S.
So despite the shaky ground of Europe, or the high valuations of equities, money and rhetoric are likely to continue to flow in their direction over the near term, making the bulls right - until they aren't, which is how the markets usually work.
I'm not going to make a prediction of where the markets will finish the year. What I will predict is that two scenarios are most likely - one in which markets find their way to a double-digit correction in the first half of the year, and then recover; and one in which markets simply continue to march higher, perhaps another 20% or so, and then collapse. The first scenario could plausibly lead to a manic recovery phase, as happened in 1987 and 1998 - and then collapse. I don't mean to sound unduly pessimistic, but the simple truth is that bull markets don't last forever, and highly leveraged ones (the current version) don't lend themselves to quiet retracements.
In the first case, we might indeed find ourselves up on the year - some sort of double-digit correction is quickly overcome, and the markets roar ever higher as everyone becomes convinced that prices can't really ever stay down again. That would lead to a 50%-plus collapse later on (not as unusual as you might think), a lot of hand wringing over central market-induced bubbles, and then we would start the cycle over again.
In the second case, we also find ourselves with a 50%-plus fall, with perhaps more immediate repercussions for the Federal Reserve and the bank finding itself under intense political pressure heading into the next Presidential election.
For now, I make the rough odds of something that can be called a significant correction (more than 10%) happening as about 20% in January-February, around 50% in late spring, and 30% in the fall. It's too early to tell whether the inversion of the usual order this week - the last day of the year rising instead of selling off, while the first day sold off instead of rallying - signifies anything more than it's been a long time since we've had a 30% up year.
Next week I'll talk more about the why and wherefore of the time frames for such outcomes, and ways to intelligently position for them. It's good to have a plan in place to anchor strategy at times of maximum noise - and try to decide in advance what constitutes a sea change, so you won't make the common mistake of letting your emotions talk you into ignoring the evidence.