Happy demi-anniversary, stock market rally. Will the honeymoon ever end?
Six months ago, this "relentless rally" took off and it has so far delivered stock investors the kind of bounty that would make for a very good year in any age.
The Standard & Poor’s 500 index bottomed at 1,353 on Nov. 15, as a sharp post-election selloff and policy panic were culminating, giving way to what has been a tireless climb that's confounded the cautious. The S&P 500 is up more than 22% since then, and up 13% so far in 2013, with healthcare, media and financial stocks leading the way — and without so much as a 4% pullback.
It’s fair to say that not many saw it playing out quite this way. Two days after the market low was set, the Wall Street Journal published Learning To Love Volatility, an essay by Nassim Nicholas Taleb, author of “The Black Swan,” the best seller that detailed the world’s knack for delivering unforeseen shocks.
Fair advice — at the time
It seemed like fair advice at the time, with investors on alert for the next economic or policy shock after five years on the crisis-and-rescue treadmill. A contentious election surprised and displeased plenty of Americans, especially wealthy stock owners, and began the ticking of the Washington-conjured “fiscal cliff” tax-expiration letter bomb. For good measure, the world economy again seemed to be slowing dramatically.
The markets were in no mood to love volatility but rather to pay up for shelter from it. The 10-year Treasury yield bottomed at the same time as the stock indexes, at a low of 1.59% not seen since. Gold, the default asset of the fearful, sat above $1,700 per ounce, not far from its all-time 2011 high.
Wall Street investment strategists were hunkered down as they rarely have been over the years, recommending clients keep less than 50% of their accounts in stocks, according to the Sell-Side Indicator – which as a contrary-logic tool has typically foretold big market gains to come.
All this clenching-up of anxiety about the uncertain future yielded to a quite-unexpected outbreak of calm. U.S. growth held up better than in other mature economies, housing activity and car sales revived, and fiscal deadlock and limp inflation data spread assurance that the Federal Reserve would resolutely continue shoveling money into the bond markets. Also, companies have continued using copious cash to buy up their own shares and investors got just enough assurance that disaster risks were contained to add risk to their own portfolios.
Market expectations of future turmoil, as measured by the CBOE S&P 500 Volatility Index, have declined by more than 25% over the past six months. Treasury yields have risen toward 2% and gold has fallen by 20%, even amid unceasing central-bank money creation.
The crucial question
The crucial question now is how far this collective "relaxation effect" can lift stocks with corporate-profit growth meager in the latest quarter, equity valuations no longer cheap and the second-half economic acceleration story still in draft form.
One way to view the equity surge these past six months is a simple re-valuation of stocks back in line with the rich pricing of bonds, in particular corporate debt, which long ago became inflated by ultra-low interest rates and the engineered confidence of a determined central bank.
The yield on “junk” bonds, which sit closest to stocks on the asset spectrum, is below 5%, which allows investors to squint and decide that 17-times the past year's operating earnings for stocks – expensive by historical standards – is OK. The outperformance of slow-growth dividend stocks along with a core elite of growth bellwethers such as Google Inc. (GOOG) shows the rally so far has largely been about paying more for certain kinds of paper.
Michael Hartnett, global chief investment strategist at Bank of America Merrill Lynch, neatly sums up the prevailing mood in a note this week to clients: “The macro backdrop remains unambiguously one of ‘High Liquidity’ and ‘Low Growth’ [but crucially not ‘no growth’]."
“We are likely to remain bullish equities, bearish bonds and cash, and neutral commodities until a recession begins or, more likely, in our view, stronger growth and anticipation of lower liquidity induce fears of a bond crash and a bout of contagion to risk assets.”
This is all quite reasonable, of course. And the “unclenching” of investor fear – along with a still-easy Federal Reserve adding cheap fuel to an increasingly sturdy domestic economy – could carry on for some time should investor confidence transmute to cockiness.
It’s a weasel-y Wall Street cliché to regard a rally and say, “The easy money has been made.” What in retrospect seems like the easy money usually came with lots of difficulty for those who were brave or lucky enough to get in on a major market move early. Still, it's tempting to render that assessment on this rally, and to point out that more and more investors seem to think the bullish case is the easy one.
The potential risk now is that too many take the upbeat view detailed above by Hartnett for granted, the way the majority six months ago was pretty sure volatility and financial hazard were going to persist indefinitely. We’re probably not there yet but we are surely getting closer.