David R. Kotok
Chairman and Chief Investment Officer
Some Frequently Asked Q&A about the US stock market.
November 15, 2010
Do you think that the bull market is over?
NO! This stock market rally started in March of 2009. It began from a level that represented massive fear and raw panic in the aftermath of the Lehman Failure. It was preceded by a severe traditional bear market from the 2007 peak to the pre-Lehman level. That bear market lost about 25% of its value. After the Lehman fiasco, the market lost another 25% in five weeks. The market then floundered and sold off from December 2008 to the March 2009 low. Why? Because the US central bank was tepid in its response to address global illiquidity. The Term Auction Facility (TAF) and the global swap lines took three months to achieve liquidity injection sufficient to unfreeze a nonfunctional financial system. The Fed has, hopefully, learned from that mistake. If the Fed is paying attention, they will not repeat it. Liquidity is no longer an issue. Stocks tend to rise over time when there is excess liquidity. That is the case today.
When will the bull market end?
No one knows and all indicators that predict a market top have their flaws. We use strategic levels to measure the risk. One of them is the ratio of total stock market capitalization to GDP. Jim Bianco computes it. So does Ned Davis. Their methodologies are slightly different. There are several other measures as well. They all tend to say the same thing: we have seen enough stock market recovery to begin to worry. However, we haven’t seen enough price rise in stocks to be fearful of anything other than a correction in an ongoing bull move in stock prices. Another 20% increase in that ratio would trigger selling on our part. We are closer than we were, but we are not there yet.
Are there any other strategic indicators?
Yes. There are many and one must examine all of them. We use the ratio of the profit share of GDP to the GDP. We believe that the higher the profit share, the more one can justify the value of stocks. Right now, the profit share is very high. We do not expect it to go much higher. The question is whether the present profit share can be sustained. If it can, then stocks may move substantially higher. If the profit share starts to erode as a percentage of GDP, then stock prices will come under pressure. This measure now requires close watching.
What about technical indicators like the Hindenburg Omen (HO), the Golden Cross, or the Death Cross?
Readers who wish to get details on these and many others like them can search for definitions. We dismissed the HO because of the way it is calculated. Art Cashin was very helpful in creating a perspective on this measure. HO may work but it did not do so during the last few months. We think it was a victim of Goodhart’s Law. Readers may google Charles Goodhart to learn what the G-Law is and how important it is. Ned Davis has done some superb research on Golden Crosses and Death Crosses. In sum, they have predictive value but the degree of value depends on whether the bull or bear market is secular or cyclical. From Ned’s data base we learn that, “Since 1929, S&P 500 Golden Cross signals that have occurred within secular bull markets have been profitable 76% of the time with a median gain of 19.9%.” That is a powerful statistic. However, Ned also notes, “During secular bear markets, Golden Cross signals have only been profitable 58% of the time with a median gain of 1.3%.” In sum, the use of the crosses depends on whether this is a cyclical bull within a secular bear or a true secular bull that started two years ago. Right now, we do not know the answer to this strategic question. It could be either one. Therefore we watch the crosses but do so with tempered enthusiasm and limited conviction.
Does QE2 help stocks?
Of course it does. Creating excess reserves in the banking system means that the funds have a bias to flow into financial assets. We see that in nearly every case of QE during the entire last century. The question is how much QE and, more importantly, how much the anticipated QE is already priced into the market. The latter item is difficult to measure. During the height of the debate and before the QE2 announcement, the market had priced as much as $1.5 trillion of QE into expectations. So the market was disappointed by the Fed’s announcement of $600 billion to be spread over 8 months. The Fed has left the door open for more, but it has not been clear on how it will make this decision or when or why. Thus, expectations have been dampened. The Fed has also focused the QE on the “belly” of the Treasury curve, with about half of it targeted at the 7- to 10-year maturity range. That seems to be targeted at the home mortgage market in order to bring mortgage interest rates down. So far this is not working. Thus, Treasury rates in the belly are lower but mortgage rates have not fallen as much. This is a weight on stock prices.
There is a great debate over QE. Does this debate help or hurt stock prices?
It hurts. Views range from “do nothing” to add $2 trillion of QE. The Fed is internally divided. All sides are argued with passion. Moreover, the global forces are mixed. This conflicting array of views is difficult for investors to understand, and that is driving some to the sidelines out of fear. In our view, that fear is a result of the trauma of the financial crisis and previous bear market. That is why there is still an opportunity to acquire financial assets. When the fear is gone the bull market will be over. In addition, when the liquidity excess peaks and the central banks start to withdraw it, the bull market may also be over. Meanwhile, it is important for investors to understand the QE debate. Paul McCulley, in his most recent “Global Central Bank Focus,” has an excellent discourse on the positive side of Bernanke’s QE initiative. Axel Merk, in a piece titled “The Dollar: Every Man for Himself,” talks about the risks and the currency issues. We recommend both essays to our readers.
So where do you stand right now?
We have been nearly fully invested in US stock market ETFs for about two years. We took the weight up in US stocks after the November 2008 meeting in Cape Town. That is where Bernanke and Trichet affirmed the need for a coordinated response to the global crisis and illiquidity. The European Central Bank acted fast and in size and was credible at once. The Fed took two months longer than we expected. During those two months of January and February 2009, the markets suffered from illiquidity. When the Fed finally caught on, and the initiative of TAF and global swaps worked, the market bottomed and the new bull commenced. We are still in it. The results have been good. The bull market is not over.
That said: the easy money in the stock market has been made. The issues that confront investors are very complex now and the influences are truly global. Change will come rapidly and volatility will be high. We are in the post-crisis period, but the aftershocks of the crisis are severe and troubling. We believe that markets will continue to climb this wall of worry, as they usually do. We do not see any of the signs of complacency that characterize the end of a bull market. We do see an abundance of fear and uncertainty. Those characterizations suggest that stock prices can and will go higher.
Our projection is for the US stock market to fully close the “Lehman Gap.” That translates into an S&P 500 target above 1300. We expect to see this occur within one year. We expect the Fed to continue its QE policy as promised. Thus, liquidity withdrawal worries are way out in the future. There are no signs of immediate sustained inflation. Commodity prices are inputs into the price level but they are NOT the price level. As long as the unemployment rate is very high, the pressure of inflation is likely to stay low.
We expect some near-term rockiness in stock prices and then another upward movement. This could commence at any time.
David R. Kotok, Chairman and Chief Investment Officer