Michael Santoli

Investors’ Mood Catches Up to Market’s Message

Michael Santoli

Suddenly, market handicappers are excitedly and loudly heralding a new period of comfort and calm.

With the U.S. economy entering 2013 on steady footing and risk appetites rising along with stock indexes toward five-year highs, it’s become fashionable to assert that the calamitous financial crisis and ensuing anxious convalescence period have given way to a phase of greater confidence and sweeter financial opportunity.

Pimco CEO Mohamed El-Erian last week tentatively suggested the firm’s signature "new normal" rubric of debt-impaired economic sluggishness could soon run its course. Raymond James strategist Jeff Saut has been getting more attention for recent musings on whether we are in a long-enduring “secular bull market” rather than a fleeting rebound. Brokerage house derivatives analysts are awakening to the prospect that stock-market volatility is settling into a more placid range. And the Washington Post’s economic site Wonkblog Tuesday heralded the start of “Barack Obama’s post-crisis presidency.”

This idea – that the agitated state of vulnerability following the 2008 crisis is fading thanks to central bank action, pent-up consumer demand and the burning up of excessive investor fear – should come as no surprise to those alert to the market’s cues.

The peaking of uncertainty

The case was made here three months ago that the dominant theme of macroeconomic and political “uncertainty” had probably peaked. And, indeed, in a 2012 consumed with hyperventilation over political schisms and a fragile world economy, the market spurned the headlines by behaving quite normally and returning almost exactly the historical norm for an election year when an incumbent president wins.

Yet now that more observers are embracing the apparent exit from crisis times, it’s important to recognize that simply recognizing this shift is the easy part. What’s tricky is determining how much of this shift has already been sniffed out and duly priced in by financial markets that have given us a 120% surge in the Standard & Poor’s 500 index in four years and the lowest corporate-borrowing rates in decades.

Indeed, the trailing price-to-earnings ratio on the S&P 500 is above 17, up two multiple points from a year ago, proof that the stock market has already been infusing share prices with greater confidence in forward earnings growth than in the prior three years, when stocks undershot the rise in corporate profits.

Keep an eye on the fuel gauge

It would be far too glib to venture that the market is posed to ambush the crowd just as it’s relaxed a bit. The risk-reward pendulum doesn’t tend to swing quite that erratically. One way to think of this emergence from the crisis’s shadow is this: We may no longer need to be on constant alert for a catastrophic mechanical failure of the system, but it’s still important to watch the fuel gauge and track wind and weather.

Fundamental and liquidity factors appear to have the stock market well-supported at the start of 2013. The main concern is an excess of investor optimism in a mature bull market that should result in at least a modest pullback soon. As for Washington drama, the debt ceiling overhang is lifting, yet it’s too early for the market to show much alarm about other impending budget fights.

An objective clue to the markets’ constructive mood is the Risk Regime measure devised by Windham Capital, a $1 billion institutional asset manager and analytics firm in Boston. It rates markets’ susceptibility to systemic risk and their demonstrated “resilience,” using real-time quantitative indicators and asset-price interactions. Both are flashing green, suggesting it’s relatively safe to assume greater risk until these winds change.

Still, identifying and profiting from broad changes in market context can be vexing. By the time a decade is named for some purported collective trait, the evolution is probably pretty far along and the clock is ticking on the period’s relevance.

The bullish interpreters

The most bullish interpreters of the post-crisis mood are keying on two related potential catalysts for a good deal more market upside. One is an expected “great rotation” from bonds into stocks by investors overloaded on fixed-income instruments, widely considered vulnerable to rising yields as economic growth proceeds.

There’s a bit of internal tension in this argument, which essentially says: “Stocks have more than doubled in four years with the public aggressively shunning equities, so the public returning to equities should power stocks higher.” The further point is that stocks are commonly called cheap, but only in relation to other assets (Treasuries, junk bonds) that the same folks consider to be laughably overvalued.

All this means is that an investor now should recognize that being bullish today represents a call that the market is entering its “overshoot phase.” That is, the part of the market cycle when most of the benefits of strong corporate profits, cheap money and declining fear levels have already been reflected in the market, but when fresh money chasing good returns and aggressive corporate deal-making is counted on to push stock values higher.

Such “overshoot” phases, if that’s what awaits, can go on for quite a while both in time and appreciation terms, of course.

To monitor ongoing market prospects, look for corporate-acquisition, leveraged-buyout and activist-investor activity to quicken. All the bullish liquidity and confidence factors widely cited should translate into many more deals and greater management urgency to deliver results. If somehow this doesn’t happen in the coming months, something’s amiss.

And watch the bond market - not for money heading out of it but for continued strength in corporate credit. The upside in stocks since 2009 has been preceded by and predicated on a ferociously strong corporate-bond market. Stocks have simply tagged along behind the high-powered money that’s driven high-grade rates below many companies’ dividend yields, and sent junk-bond yields below 6%. When that party ends, stock investors might also want to start looking for their coats.

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