Monday, March 19, 2012

The equity rally has legs

The equity rally that began almost six months ago has legs, since it's being driven by improving economic and financial fundamentals, and the rise in Treasury yields is a key indication that this is the case. Yields had been (and remain) severely depressed because global investors had almost no hope that the U.S. economy would improve or that the world would avoid another painful recession. Instead, we see a steady stream of better-than-expected economic reports suggesting the U.S. economy is slowly improving. This forces investors to reconsider their love of Treasuries and their aversion to equities. In that sense, this is a rally driven not by optimism but by reduced pessimism. Treasury yields would need to be much higher before I would consider the market to be driven by optimism.

This chart shows how the improvement in Eurozone banks' ability to acquire dollar funding (as represented in a declining blue line) has led the reduction in Eurozone swap spreads, which in turn is a good indication of improved general liquidity conditions and reduced systemic risk. When financial markets are liquid they can and do function as shock absorbers for the physical economy, because they allow market participants to shift the burden of risk to stronger players. Spreading the burden of risk, in turn, facilitates economic growth, and growth is the best remedy for the problems that still plague Europe.

Financial conditions in the U.S. have returned to "normal" and Eurozone financial conditions have improved significantly, although they remain somewhat precarious. Europe needs more convincing structural reforms (e.g., lower tax burdens and a reduction in the size of the public sector) before the outlook can turn positive.

This chart shows the market's 5-year, 5-year forward inflation rate, a good measure of near-term inflation expectations. Note that expected inflation has increased by half a point since last October, from 2.0% to 2.6%. I take this to be an indication of how, on the margin, the market has become less concerned with the threat of deflation, and more concerned with the risk that the Fed's ultra-accommodative monetary policy may be exacerbating inflation risks.


Squire said...

I am amazed at the many intellectual pieces I have read over the last few days and today on the reasons why the stock market is overvalued and why the economy is going to contract and why it will bring down the stock market.

When the S&P corrects from 1500 to 1450 before resuming its upward path, these authors will be patting themselves on the back.

The Russell 2000 which had gotten ahead of the S&P 500 and has been consolidating, has so far today, confirmed the S&P with its own break upwards.

Junkyard_hawg1985 said...

Long term I am optimistic, but I'm not convinced the secular bear market is over. Quarterly, I review the financials of the 30 companies that make up the Dow 30. The good news is that the net debt of the Dow 30 has fallen from $999 Billion at the end of 1Q10 to $624B at the end of 4Q11. This a nice improvement.

Here is why I'm not wildly bullish. The parameter I care about most is enterprise value/revenue. It takes into account a company's revenue, net debt and shares outstanding. If a comany uses its profits well, they can grow revenue, buy back shares, and reduce debt over time. On 12/5/07, I evaluated the financials. The Dow was at 13,445 and the median EV/rev was 1.86. On 3/14/12, I did the same analysis. The Dow was 13,194 and the EV/rev was 1.86. Based on the median EV/rev, the dow today is as expensive as it was on 12/5/07. 12/5/07 was not a good time to buy.

William said...
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William said...

Schaeffer's Investors Intelligence 3/14/2012:

Percent Bulls - 43.6%
Percent Bears - 26.6%

The % Bulls dropped from 51.1% just two weeks ago while the % Bears rose 1 %. Those looking for a correction rose from 23.4% to 29.8%.

Meanwhile, LIPPER FUND FLOWS showed that for the week of 3/7/2012, $3.8 Billion was withdrawn from stock mutual funds and ETFs and for the week of 3/14/2012, $9.6 Billion was invested. For the same two weeks, taxable bond funds and ETFs had inflows of $5.3 and $4.4 Billion respectively.

My sense is that many folks are looking for a big stock market Summer correction as was experienced in 2010 and 2011. I suspect that many of them didn't buy much last September and October and are hoping (desperately perhaps) that they will get another chance.

My "hunch" is that they won't get a huge sell off - maybe a sideways correction instead. Personally, I will closely watch the ERCI data for improvement (desperately perhaps).

Benjamin Cole said...

If the Fed would act to guide the economy to growth and price moderation, we would have ourselves a sustained secular bull market.

Right now we have Fed regime uncertainty, and a peek-a-boo Fed. The Fed should just say it would target 8 percent nominal GDP growth for several year.s