An observer of the U.S. equity market would have to conclude that it has a strong bullish bias these days. Despite the weak economy, a clouded earnings outlook, persistently high unemployment and the eurozone crisis, the market shrugs off bad news and soars on anything that can be construed as good news, no matter how tenuous.
The Fed fumbles the ball, the Bundesbank shows Draghi who's boss, Southern Europe teeters on the brink of something awful--no problem! All news is good news. Girls just want to have fun and the market just wants to go up.
Why is this? Is the stock market irrational? If so, it is being paid to be irrational.
What is happening can be summarized in one cliche: Don't fight the Fed. Since 2007, the Fed has: cut the overnight rate from 5.5% to near zero; grown its balance sheet from $800B to $2.7T; and driven down 10-year Treasury yields from 4.6% to 1.6%. (For comparison with equities, the Fed has bid up the PE ratio for Treasuries from 22 to 63, not exactly "value" territory for a security whose earnings can't go up.)
The Fed has systematically banged fixed income yields down to levels not seen in 50 years. The Fed is charging investors for holding bonds and paying them to hold stocks.
At present, the estimated forward PE on the S&P 500 is 13.3, the earnings yield is 7.5%, and the equity risk premium (earnings yield minus bond yield) is 6%, which is historically high. If you were a fiduciary, you would be hard-pressed to defend an overweight in fixed income when it yields nothing, versus equities that offer an attractive 7.5%.
The case for equities is compelling, and the relative "economic return" almost requires you to sell bonds and buy stocks. When stocks get this cheap and bonds get this expensive, most bad news has been fully discounted. Future news will have to be really, really bad to hurt stock prices.
To be bearish (like me), one has to expect catastrophe with a pretty high probability. A catastrophe that is bad enough to drive investors out of all risk assets and into Treasuries, and to keep them there by hitting the earnings outlook or cratering the financial system.
The equity market went through that exact scenario in the six months from September 2008 until March 2009, when the Dow declined by around 40%. That was because of a panicked flight to safety; it had nothing to do with relative yield. No equity market, no matter how priced, can withstand the risk of imminent financial collapse (see 1931-32, when the Dow fell from 190 to 40).
If an investor believes that Europe will figure out a way to save the eurozone, he should be in equities (SPY), because they are already priced for very bad news. If you believe, like me, that things will get much worse before they get better, then you should be underweight risk assets and long assets like TLT and GLD. But you are taking the risk that the world does not end this year. If we're still buzzing along in January, you should have stayed in equities.
The Dow has doubled since the crisis bottom, and the whole time there has been an overhang of really bad things; the market has, as they say, climbed a wall of worry. You therefore have to be both very bearish and very phlegmatic to bet that the world is going to end soon enough for you to make money.