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One of the things we’ve liked about the present market environment is the bulls are nervous, even a little embarrassed, and the bears are confident. And as we find ourselves yet again at another mid-year point where summer nerves seem to be hitting, we find ourselves in the uncomfortable position yet again of being the “Pollyanna” in the room. To this we say, “Bully!” (Pun intended.)
First, let’s take a look back at this year. After growing a bit cautious in January, we got back on board the equity train on Feb. 7 (“Secular Bull Update: Time to buy the dips again”) when the S&P 500 was down to 1,798, and reiterated this call on March 20 at 1,872 (“Secular Bull Update: Spring thaw could become a melt-up”). Later, on May 2, we warned, “Sell in May? Not this year” with the S&P still below 1,900 at 1,881.
So now the wise-sounding call, probably, would be to declare victory and yell “sell,” or at least “correction,” here. And certainly those who have been with us on this ride upward since 2009 could point to a near triple in terms of returns, which is itself scary, against an economic expansion which has extended nearly 60 months, a bond market whose low yields could be signaling rough economic waters ahead, and a variety of global political and economic risks running from the Ukraine through the Mideast and right to China.
It’s not when does it end but when did it begin?
It would, in that sense, perhaps be easy to say go ahead and take your gains. The money has been made. Regrettably, however, I can’t in good conscience advise our clients to sell here. From our perspective, we have just recently exited a 13-year secular bear market in equities, with the S&P today 26% above its peak in 2000—a nominal return of just under 2% per annum over these miserable 13 years, below the rate of inflation. Over this same 13 years, nominal S&P earnings have risen from $68 per share to over $110; nominal U.S. GDP, which the S&P is in some ways a call on, has expanded from $10.3 trillion to $16.8 trillion (global GDP, by the way, has more than doubled); and the investment alternative, the U.S. 10-year Treasury bond, has seen its yield fall from 5.1% to 2.6%.
Rather than ask how close to the end are we, we think the correct question is how far from the beginning are we? Our answer: not far. In fact, as skeptical as everyone is at the moment about the future, we think we will look back on mid-2014 and ask ourselves: “How could we have missed this? We were in ‘Goldilocks Cubed’ and we didn’t buy!” Let me explain.
The “Goldilocks” scenario was frequently used to describe the U.S. economy and equity market in the mid-1990s. Referencing back to the old children’s fairy tale, the concept was to have an economy growing “not too hot, and not to cold” that would allow for a gradual expansion in the economy and corporate earnings, while keeping the Fed on hold—and equity valuations stable. Between 1994 and 2000, this sort of happened. Real U.S. GDP growth averaged 3.8% per year, Fed policy kept the 10-year Treasury yield mostly in the 5.5% to 6.5% range, earnings grew 8% per year, and the S&P rose 21% per year.
Interestingly, what really drove the “Goldilocks” outcome was the mania which developed in the back half of the decade in technology, telecom, and media stocks, the so called “new paradigm.” This all came to tears when the 2001 recession hit and the bubble in technology-media-telecom stocks burst.
‘Will the real Goldilocks please stand up?’
This time around, with investors trained on a 13-year bear market in equities and fretting the “end must be nigh!” and crowd psychology focusing yet again another “new paradigm”—the bearish scenario called the “New Normal,” we think we are entering a real Goldilocks scenario, which we are calling “Goldilocks Cubed.” First, we think the foundation for economic acceleration is extremely well laid, and with this, we expect earnings to accelerate to $120 per share this year, and higher still in 2015. We’ve presented these arguments in some of the pieces cited above, but to summarize: after a seven-year period (2007-13) when the end of the world seemed to be lurking around just about every corner, U.S. businesses and consumers now find themselves massively underinvested with piles of cash all around them.
As the predominant psychological force in the crowd shifts from fear to greed, almost all forward indicators of an advance are pointing to expansion: bank lending, manufacturing ISM, non-manufacturing ISM, retail sales, consumer confidence, business confidence, M&A activity, etc. This time around, with corporate managers running their businesses lean and mean to prepare for the worst, our bottom-up work suggests that the nominal GDP pickup is going to drop straight through the income statement to the bottom line. This represents earnings acceleration—the first half of a Goldilocks.
Valuations’ two drivers
The other half of a Goldilocks is valuation expansion, which this time we think has two drivers working simultaneously—hence, “Goldilocks Cubed.” One driver has been at work since 2009, when the world really did nearly end, but didn’t: the decline in perceived risk. This gradual realization that risk was on the decline has in fact been almost the sole driver of the equity expansion to this point, with the S&P P/E multiple rising from under 11 times in 2009 to over 15 times today, and the VIX “fear” gauge dropping simultaneously, from north of 60 at the peak of the 2008-09 crisis to just 12.5% today.
Most market participants keep telling me that perceived risk as measured by the VIX is now “artificially low” and bound to “return to normal” any day now. Really? Scarred by the last seven years, most folks are defining “normal” as this period, when the VIX did in fact spend a lot of time above present levels. But in more benign, boring environments (such as the one we think we’re heading into), the VIX has spent years in low double digits (for e.g., 2003 to 2007, and 1992 to 1996). Today, even with the spot VIX at 12.5, the 12-month forward curve has it much higher, near 19%—so investors continue to expect volatility to rise again, and are pricing this into risky assets such as equities. What if the reverse were true? We think it is.
The second driver of the valuation expansion we see coming is the yield on the 10-year Treasury bond. Investors believe that as we return to “normal,” the yield on the 10-year should rise, probably substantially, maybe to 4.5% (our own house call, by the way). This would be the natural outcome should the economy accelerate as we expect. But the recent rally in the bonds has taught us something: bond yields are driven in part by the economic outlook, but also in part by global supply and demand. The latter, frankly, is very bond friendly.
Altogether, just right
We have central banks all over the world still in QE-mode (even our own Fed is promising to keep its bloated balance sheet bloated long after tapering ends). With government deficits dropping quickly as their economies expand, these quantitative-easing programs are effectively buying up a larger and larger percent of the new supply of government bonds. At the same time, geopolitical uncertainty outside the U.S. and Europe is driving up demand for the perceived safety of U.S. and European government debt. So both supply and demand forces are keeping yields artificially low, even as equity risks are declining and equity earnings are rising.
With sentiment broadly skeptical at best, we’d argue this—declining equity risk ,rising equity earnings and prolonged low yields—is a recipe for another big up-leg in equities. It’s a recipe for “Goldilocks Cubed.”