By Andrew S. Parlin
There are two decidedly different ways to look at the market’s rally.
The first one invites caution. From its March 2009 low nearly four years ago, the S&P 500 has compounded at a spectacular annual rate of 24%. Against the backdrop of a long list of “overbought” signals, a cloudy earnings picture, and an economic recovery that appears to be struggling, why not bail? After all, this has been one heck of a good run.
The other way to think about the market is to study its progression since WWII and note that the two very long secular rallies (1942-1968 and 1982-2000) were punctuated by two periods where the market took a very long time to advance to new highs (1968-1982 and 2000-?). This approach would acknowledge that markets may well be extended on a short-term basis. But it would also beg the question whether we may at last be coming to the end of one of those protracted periods of going nowhere.
At the Inflection Point
During the 14-year period from 1968 until the summer of 1982 the market did anything but move sideways, yet it was well capped on the upside throughout the entire period save for a brief fake-out in late 1980. It then broke out furiously beginning in mid-August 1982 as the market recognized that the long hard battle against inflation had finally been won. Similarly, today, the market may well be signaling that Bernanke is winning one of the most obstinate battles of disinflation since that Great Depression. Perhaps the long nose of the market is sniffing out a pickup in GDP growth and a return to more normal times. This would include a healthy inflation cushion of 2.5-3%.
Markets do indeed appear to be at an inflection point. We seem to be leaving the post-crisis era of what might best be called the “reluctant rally” of 2009-2012 and entering into a new phase marked by a structural shift in asset allocation preference and even a healthy return of greed.
Credit the Fed
What is the basis for such optimism? After all, didn’t GDP contract slightly in the fourth quarter? While it is true that growth has been disappointing, the headwinds that have restrained GDP are abating. The big macro uncertainties of Europe and China have receded dramatically. At the same time, with each passing month we get closer to greater clarity on how the fiscal cliff standoff will play out. Even a bad deal will at least remove the scary nature of a big unknown. The diminishing risk of fat tails will allow the cumulative impact of negative real interest rates to gain traction.
Quantitative easing is working. It has kick-started a recovery in housing and autos, traditionally the two key leading sectors of recovery. It has also led to extremely buoyant conditions in credit markets, a boon to medium-sized businesses. What few investors have realized is that the Bernanke game plan is meeting with tangible success. This explains the market’s extraordinary resilience. But whereas QE1 and QE2 were crisis-fighting policies, QE3 was designed as a proactive, outcome-based program. The desired outcome? An unemployment rate of less than 6.5% (versus today’s 7.8%).
This Is Not a Bubble
Only a much faster rate of economic growth can drive unemployment down to that level. The sequencing is really quite simple. Keep rates across the whole maturity spectrum low enough for long enough and capital markets are lifted above a critical threshold. What is that critical threshold? The point at which financial conditions become so benign that they awaken good old animal spirits in the real economy.
While some dismiss Fed policy as creating the next bubble in credit markets, this is a misuse of the word bubble. A bubble describes an excess that eventually self-destructs. This, in contrast, is a healthy tonic for a very fragile economy. It is the only pathway out of a long-lasting liquidity trap. Just ask the Japanese about whether liquidity traps cure themselves. They don’t. It takes a policy shock. This is exactly what the Fed is delivering. The precondition for a better economy is a powerful and long-lasting rally in stocks and credit, thus driving down the cost of capital for American business.
More to Come
We are reaching a turning point where robust capital markets finally inject optimism into corporate decision marking. Recent activity in M&A is reflective of this. And it suggests that we are on the cusp of a new cycle in private capital spending. All of this points to an improvement in labor markets, better growth in personal income and a sustained improvement in final demand.
The really good news is that Bernanke knows all too well that monetary policy must remain highly accommodative until the economy is without any question on a firm footing. After all, it was the premature withdrawal of monetary stimulus in 1932 that turned a recession into the Great Depression. We are a long way from the next tightening cycle, particularly given a very large output gap and the contractionary impulses that are about to come from higher taxes and smaller public sector outlays.
Rarely do central bankers keep such forceful monetary stimulus in place well into an economic expansion. But this is the unusual dynamic at work today. It is nirvana for stocks, which is why the 128% advance off the 2009 lows should be viewed as little more than a return to baseline. The next big secular rally has just begun.
Andrew Parlin is co-founder of Kotell Advisors LLC, an investment company based in New York City