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Summary

  • We have benefited from a prolonged multi-decade bull market in bonds and a sharp equity market rally post crisis.
  • The slope of the treasury yield curve indicates no change to current market trends.
  • Credit capacity is high for both commercial and household borrowing.
  • We are bullish on the US economy and US equity markets.

Equity markets in the US have bounced back over the past couple of weeks and have shown strong momentum to the upside. We are now well into the fourth year of a rising equity market and we might now reasonably ask the obvious questions: When this might end and how should we allocate our capital?

Lets put the current interest rate and equity market into historical context.

(click to enlarge)

We have been experiencing a prolonged bull market in USTs since the early 1980s and we are in the midst of a strong equity bull market dating back to the end of 2009. The most recent equity bear markets can be seen on the graph (sharp fall in the red line above) coinciding with the last two recessions, in 2001 and 2007-2009.

So how long will these two bull markets run and do we see any signs of a turnaround?

To answer this question, we look a little closer at the current business cycle to assess where we are in its progression.

Interest rates

Historically, the slope of the yield curve has been an accurate predictor of the business cycle.

(click to enlarge)

In the graph above, we have plotted the difference between the 10 year constant maturity ("CMT") UST rate and the 1 year CMT UST rate. This indicator fits well with the business cycle. The slope accelerates upward through a recession and is at its steepest soon after a recession during the early phase of an economic expansion.

The slope reduces or in other words, the yield curve flattens, through most expansions, eventually turning negative (yield curve inverts) just prior to a recession.

As you can see, there were a couple of false readings of inverted yield curves with no immediate recession but there were no instances of a recession while the curve was flattening after displaying a positive slope. Even the false readings were slight, temporary, and eventually predicted a recession.

The overall cycle of the shape of the yield curve fits nicely with the economic cycle and indicates that we are currently nowhere near a recession.

So how much gunpowder is left?

And how long can this expansion run? In our last article we looked at velocity of money, Fed QE policy, capacity utilization and employment to get a sense.

This time we present our thoughts on commercial lending activity, banking reserves, and household credit capacity. All indicate plenty of capacity and the ability to drive the economy forward for several years to come.

Commercial lending is expanding

Bank balance sheets have peaked but this masks underlying loan growth.

(click to enlarge)

Although total interest bearing assets of the top 100 banks in the US have remained level (even decreasing slightly) since 2010, underlying commercial and industrial loans (red line above) have grown at a good pace. Total assets of banks have been skewed by the extraordinary purchase of non-productive financial assets immediately following the global financial crisis and don't imply consequences for the economy.

However, the rate of change of commercial and industrial loans fits nicely with the business cycle. As we can see from the graph, over the past three cycles, loan growth (the red line above) bottoms soon after a recession, turns upward, accelerates, and tops out just before or in the midst of a recession and turns sharply downward until private sector credit demand returns. Currently, we see the red line on an upward slope with no indication of flattening or reversing.

Excess reserves are at extremely high levels

Reserves are high in part due to changing regulations, but at these levels, credit creation will have to accelerate as confidence and sentiment continue to improve.

(click to enlarge)

The picture looks the same even when considering the data in log scale.

(click to enlarge)

Household balance sheet repair near complete

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Household debt service payments as a percentage of disposable income are the lowest they have been in three decades. Although mainstream media stories abound of pinched consumers facing hard times, the data indicates that households certainly have the capacity to increase spending and incur additional debt to power the next phase of economic growth.

Conclusion

In summary we are bullish on the economy and the equity markets in the US. We see no signs of disruption beyond an exogenous geopolitical event.

The current S&P P/E ratio is 18.55, as reported by the Wall Street Journal data center, and 19.39 as reported by Barron's. This is relatively high but within a historical range we might call normal.

Consensus estimates of earnings vary, but with our bullish view on the market, we would not be surprised to see EPS for the S&P 500 grow by between 8% and 10% year-over-year.

Based on our expectations of earnings growth and a slight expansion in the P/E multiple, we would not be surprised to see the S&P 500 index reaching 2400 by December 2015.

Asset Allocation

Equity

Bonds

Commodities

US

Overweight

US

Overweight

Gold

Underweight

Europe

Underweight

Europe

Flat

Oil

Flat

EM

Flat

Japan

Flat

EM

Overweight

Investment Themes

As discussed in previous articles, Armchair Quarterback is focused on investment themes related to industry disruptions caused by changes in public policy and technology innovation. We have initiated coverage on the solar sector with utilities, oil & gas, wind and transport to follow soon.

Solar

Wind

Utilities

Oil & Gas

Transport

Overweight

Flat

Underweight

Flat

Flat

Source: The Bull Market In Equities Has A Long Way To Run