Bulls and bears fight it out
by Raul Elizalde - 2014-10-21
After two years of virtually uninterrupted gains, the stock market took a scary tumble in October. Opinions are divided on what this means.
The bulls think that the dip is a buying opportunity because the economy is strong and the Fed’s ongoing stimulus places a bottom on asset prices. The bears say that the economy is vulnerable to serious global challenges against which the protection that Fed policy supposedly provides will come short. The fight between the sides is closely contested, and investors are caught in the middle. Erring on the side of prudence may be the way to go.
Divided opinions are a good thing. The alternative is the herd mentality that prevailed after the financial crisis, when everyone panicked or rejoiced at the same time. This pushed up volatility and created a “risk-on, risk-off” environment which made it very difficult for regular investors to stick to their plans. The sharp and sudden market turns became intolerable and some opted to stay out of the market altogether. Those who did missed a huge rally.
But today’s split opinions, while preferable to the herd mentality, reflect something different and worrisome. There is a feeling that a new and unfamiliar set of challenges is setting in.
During much of the crisis’ aftermath the focus was on how well economies were able to shake off the causes and consequences of the 2008-2009 crisis, such as whether the banks restored their capital, consumers could get loans, or countries reduced their debt. Progress or setbacks on those fronts determined whether the market went up or down. But many of those items no longer seem relevant to evaluate the market outlook. Today's difference between bulls and bears stems from the fact that they have picked different issues to focus on.
The bulls point to the fact that buying every dip since 2009 would have been a winning strategy, even when US economic fundamentals were weak. Since the US economy is vastly improved, it follows that high equity prices are justified, and are likely to climb higher.
It is true that corporate earnings, arguably the most important drivers of equity prices, are at an all-time high. While in the wake of the financial crisis they improved because of relentless cost-cutting, today they are rising because of strong revenues. One proof is that retail sales and sales per share are at record levels. Since the US economic recovery is strong and accelerating, it stands to reason that revenue will continue to grow. Virtually every important economic number supports this view:
|- jobless claims are at the lowest level since April 2000|
|- industrial production is at a record high|
|- capacity utilization is at its highest level since June 2008|
|- quarterly gains in real GDP have reached levels last seen in April 2006|
|- the estimated Federal Budget deficit for 2014 collapsed to 2.8%, below its 40-year average|
|- consumer sentiment is at its highest level in 7 years|
|- a strong dollar brought down the price of oil, cutting transportation and energy costs|
Almost all economic indicators that matter for stock prices are pointing upwards. And the fact that the Federal Reserve is not satisfied with the US economic recovery provides even more fuel to the bulls’ argument that the market will keep going up, because it means that monetary stimulus will remain in place.
But most of the economic indicators that the bulls cite as strong foundation for higher stock prices were also at or around record territory shortly before the bear markets of 2000 and 2007. Bears point out that a good economic performance can quickly hit a wall when a crisis descends upon the land.
Europe is the most obvious danger to the world’s economy. The Eurozone has reached the brink of deflation, economic activity has ground to a halt, and its labor markets are nothing short of miserable as France, Italy, Spain, Portugal and several other counties deal with double-digit unemployment rates.
We have written at length about the wrong-headed policies, spearheaded by Germany, that have dragged Europe to this juncture. The worst outcome for the Eurozone would be if full-fledged deflation takes hold, which is far from a remote possibility: the German Government 2-year bond has been trading at negative yields for almost two months. If deflation sets in, the area will suffer a long period of economic contraction.
Global sales of S&P 500 companies amount to 46%, or roughly half, of their total revenue. This is a huge exposure to the rest of the world. If Europe were to suffer from an extended period of economic malaise and China does not stop the rapid deterioration of its housing sector and industrial output, the US will not be able to maintain its strong economic performance. The global economy is just too interconnected to expect the US to float above a sinking world.
But what about central bank stimulus? If the Fed and the European Central Bank (ECB) keep injecting money, buying assets, and keeping rates close to zero, shouldn’t that be enough to keep the world from slinking back into recession?
A frightening thought is that ongoing monetary stimulus may be close to become irrelevant.
For starters, the ECB appears to have stepped back from aggressive policy as a result of strong German opposition.
After a short period when Germany seemed to have softened its opposition to ongoing stimulus, it has returned to the speaking circuit with a renewed hawkish tone. The practical result of this recalcitrance is that the size of the ECB’s balance sheet has shrunk, and details have not emerged on possible asset purchases announced about a month ago. Policy clashes between France, Italy and Germany have become public, and Mario Draghi’s tone has lost much of his “whatever it takes” bravado of the past.
On this side of the Atlantic, the Fed’s accommodating policy has become increasingly ineffectual, as the large increase in money supply has been met with decreasing demand for all those extra dollars. More money doesn’t mean much when the government spends less and consumers and corporations, especially banks, pay down their debt.
So these are the two issues that divide opinion today. When bulls look at the US, they see a bright future. When bears look at the rest of the world, they wonder how long the walls of US Fortress will be able to withstand the forces that threaten to pull the market down.
It is difficult to imagine a scenario where Europe can extricate itself from its current predicament without substantial changes in fiscal policy. The opposition of Germany makes it almost politically impossible to effect change until it is truly too late. And the ponderous and deliberative decision-making process embedded in European governance makes it structurally impossible to move any faster.
The bet that bulls have made is that the US’ economic strength is impervious to weakness elsewhere, and that it has the power to save the world. Europe is very clearly hoping for the same thing. This used to be a good bet to make when the US was by far the largest world economy, but that’s no longer the case: Europe is larger, and China is about 60% the size of the US economy.
What to do? Both sides have strong arguments, and the balance may be tipped one way or another by some unpredictable “externality”, as economists say.
Our advice is to err on the side of caution. This has an opportunity cost. Investors who have maintained aggressive portfolios until now may want to think whether that cost is higher or lower than the potential rewards. This is not an easy calculation to make. But given how little the market has reacted to the increase of global risks, lowering risk exposure seems to be the more prudent strategy, at least until clarity – one way or another – is regained.
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