Are U.S. Stocks Severely Mispriced?

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Includes: EPI, EWY, PEK, PIN, SCIN, SKOR-OLD, UPRO, YAO
by: Jack Holland

A recently published monetary policy study by Andrew Filardo was conducted on behalf of the Bank of International Settlements. It's entitled The Impact of the International Financial Crisis on Asia and the Pacific: Highlighting Monetary Policy Challenges from a Negative Asset Price Bubble Perspective. An astute investor may be able to ascertain striking similarities and applicability of the study to global markets as a whole. For U.S. investors looking for direction, the information may be something to consider when making a decision as to what direction the U.S. Stock Market is about to take:

In the case of negative bubbles, monetary authorities have to be wary of the fragility of private-sector confidence. When financial markets and investors are jittery about the future, prices of assets can become volatile. Such uncertainty will reduce substitutability across asset classes—and lead to significant mispricing. Overpricing of risk can raise the cost of borrowing, and the ensuing volatility in these costs can adversely affect the monetary transmission mechanism. As history has shown, monetary policy actions may be needed not only to counter the financial headwinds but also to restore confidence. And, even in the case where there is little evidence of a negative bubble, the mere possibility of a negative bubble may call for aggressive action from central banks in the form of a more accommodative stance on monetary policy than would otherwise be the case.

Although this study was written to address such asset bubbles in Asia, the paragraph above appears to sum up U.S. market sentiment as it currently stands. The logic of the study appears to be transferrable to the current situation unfolding in Europe as it affects not only Asia, but also the United States of America.

If deemed applicable, the logical follow-up would be in the form of a question: Does Ben Bernanke have the courage to stand up to the GOP anti-Fed Presidential Candidates and take one more bold quantitative easing step prior to the 2012 Election?

There is more than enough evidence making its way through the market to suggest U.S. equities may be underpriced. But then again, that depends upon whether or not the risks associated with Europe are big enough to warrant downward pressure on U.S. Equities as an asset class.

The study also notes the following:

…these policy concerns arise in economies subject to domestically driven bubbles and also in economies subject to spillovers from other economies. Clearly, strengthening fundamentals—monetary, fiscal, and the financial system—are all important. Developing strategies to address spillovers is also important—just in case. And market confidence that an economy has a robust policy framework in place to counter periods of stress may by itself help insulate economies from the spillovers from ever reaching their shores.

Should the U.S. investor uncover enough evidence to support the notion that a negative asset bubble has been built into the price of U.S. Stocks, one might assume that when the tide turns for an upward run of U.S. Stock Prices, the run up might be fast and furious.

The author of the study hints that such a run-up may be on course for Asian equities with the following remark conclusion:

Finally, as this paper has emphasised, these policy concerns arise in economies subject to domestically driven bubbles and also in economies subject to spillovers from other economies. Clearly, strengthening fundamentals—monetary, fiscal, and the financial system—are all important. Developing strategies to address spillovers is also important—just in case. And market confidence that an economy has a robust policy framework in place to counter periods of stress may by itself help insulate economies from the spillovers from ever reaching their shores. Such considerations may be rather important today as the long fight against the tail risks associated with a negative asset price bubble appears to be laying the foundation for frothy asset markets in Asia and the Pacific.

If the author of the study is correct, then the U.S. investor may soon have two fronts in which to invest, the US and Asia.

That being the case, building up a position in ETFs for China, India, and South Korea might be prudent choices for those that believe in a full blown Asian recovery. Investment in South Korea may present an excellent long-term opportunity after the South Korean legislature approves the recent changes to the U.S. - South Korean Free Trade Agreement. The agreement is currently under consideration by the South Koreans.

Investors may wish to consider the following:

Investors that follow Asian markets may also find reading the entire study mentioned above warranted.

For U.S. Investors, the choices are endless. You can basically pick your favorite growth stock that has good underlying fundamentals and go in for the ride.

I personally like UPRO, but once again this is triple leveraged ETF play on the S & P 500 that is not for those who are risk averse. With UPRO one can be wiped out should the market run against him. Check with your personal investment advisor in order to determine if this ETF is appropriate for you.

My opinion is that when the market turns around for the next big run-up there will be plenty of opportunities to pick an entry point provided the investor has cash ready to invest.

However, I am not yet convinced the market has bottomed out, and the European uncertainty has not been alleviated simply because new leaders are in place. Fiscal and monetary action must be taken first.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am currently long SPXU.