One reason is that finally we are experiencing coherent policy actions by governments and central banks around the world.
I think that there can be little doubt that this has occurred. While there are still policy measures that are yet to be announced, I believe this factor has pretty much played itself out. At this point, the risk of governments messing things up may be fairly equally balanced against any further upside from policy initiatives.
I think we're seeing, for lack of a better phrase, a dramatic turn in the economic growth dynamic. I think we'll continue to see very strong momentum in the economic data through June and possibly July. Economists' and analysts’ numbers are still too low, and so the surprises throughout the second quarter will continue to be to the upside.
Indeed, several are actually going to show positive growth! The blue-chip economists haven’t figured this out yet. This is going to be a shocker and will keep the rally going.
Consensus economic views are far too bearish.
This is still the case. The media is filled with pundits talking about the “certain collapse of the dollar,” “currency debasement that will inevitably lead to inflation,” and “crushing debt levels.” Most of the arguments in favor of these apocalyptic views are based on discredited ideological precepts that have become urban legends and have very little empirical evidence to support them.
Simply put, things are not nearly as bad as the consensus thinks. Over time, many are going to develop doubts about the bearish consensus. Many will start to wonder whether the celebrity Cassandras really have it all figured out.
Further, many are going to be surprised to find that behind the confident proclamations of doom, there's precious little substance to back it up.
The final stage of this rally will be characterized by a breakdown of the bearish consensus and the development of narratives throughout the financial press that would have been unthinkable just a few weeks ago.
As such, valuations are inexpensive. Equity prices have massively overshot to the downside and were extremely undervalued in March. Valuations had reached a point that reflected “irrational despondence,” and will only begin to enter into a "normal" range when the S&P 500 crosses above 950. The midpoint of the “normal” valuation range is 1,100. I think the S&P may reach 1100; possibly even 1350.
Not only are we experiencing policy actions, but they are actually being implemented. In this regard, there are 2 key variables that are going to have huge effect on the economy and financial markets.
First, the massive fiscal stimulus in the form of rebate checks, tax breaks, and massive government spending is going to start hitting the economy in a big way starting in June, and will accelerate throughout the year; I believe the biggest impact will actually be felt between June and September, when individuals and businesses begin to alter their behavior patterns in anticipation of the stimulus. In particular, businesses will start ramping up in terms of stocking inventories, buying equipment, hiring, etc. Thus the impact of fiscal stimulus will be felt even before the government actually disburses the funds.
Second, and by far the most important, the massive “liquification” being engineered by the Fed and the US Treasury through various programs such as TALF and others will galvanize the economy. These programs will only really get going between June and September. These massive injections of liquidity are going to dramatically bring down spreads in the corporate debt market, which will allow companies to rollover and renew their credit facilities and access credit at very affordable prices, thereby unfreezing credit-dependent economic activity. I’m not talking about adding long-term debt here. I’m talking about credit lines for working capital, import-export finance, etc.
The liquification is also going to reduce borrowing costs for many firms and individuals. This will act as a massive “tax break.” Individuals can free up between $100-250 per month in mortgage costs; businesses will also save money due to lowered interest costs, and the funds can be deployed for investment.
The market hasn’t yet realized the dramatic impact these Fed and Treasury programs are going to have on economic activity. Again, although the major liquification will occur from June 2009 thru March 2010, financial markets will likely have discounted the impacts in the form of dramatically lower spreads and higher equity prices by June or July.
Another reason is that cash positions remain extremely high. However, I predict this will change, insofar as these are symptomatic of high levels of risk aversion. As risk aversion declines, cash positions will decline as well, and equity allocations will rise.
As the VIX reverts from high levels above 40% toward normal levels below 20%, this is a clear indication of a dramatic decline in risk aversion. This will almost certainly be followed by a decline in another risk-aversion indicator: cash allocations.
Please note that rising long-term government bond yields, along with a declining dollar, could also indicate declining risk aversion and reduced cash allocations. The financial press may initially interpret these bearishly as signals of potential inflation and/or a loss of confidence. However, if accompanied by a contraction in private-market credit spreads, these will, as a strong confirmation of the decline in risk aversion, be a bullish sign.
The massive flow of cash into equities will be a primary driver of the market. When this sort of stampede gets started, valuations will, to some extent, cease to matter.
As a result, performance anxiety ensues. Many have predicted that the shift in risk preferences is permanent, and that cash levels will remain high. I don’t think so.
In my view, the average American is simply not going to be able to resist getting back into the market to try to “make back” the losses they suffered in 2009. The average American won’t be able to resist feeling that the Jones’s might get ahead of him, and has been trained to commit money to stocks in a constant and steady fashion. It’s deeply ingrained into the culture, and culture doesn’t change in 6 months. Americans will tend to revert to their trained habits, and are going to feel very uncomfortable being out of the market.
Institutions similarly simply aren’t going to be able stay on the sidelines, either. Cash positions doom them to underperformance. And for institutions, losing money is far preferable to underperforming.
Hedge funds also have extremely high cash levels. Hedge funds aren’t paid 2% to 20% to hold cash. Soon they’ll be throwing in the towel and aggressively entering “at the market” buy orders.
Another technical reason is the rampant bearish consensus. This countertrend rally has been characterized by rising put/call ratios and increasing short interest. In addition, for several weeks there has existed an almost universal consensus amongst analysts -- and technicians in particular -- that the sharp rise since March has been “unhealthy,” and that the market “needs” a correction.
First, the idea that the market “needs” a pullback is nonsense. The market doesn’t “need” anything. And it certainly doesn’t need to behave in a fashion that technicians are comfortable with. On the contrary, the market will tend to move in ways that confound the consensus.
Second, the market didn't pause much on the way down, so why should one expect it to pause on the way up? The technical principle of symmetry would suggest that the recovery will mirror the fall.
Another point: How is it that if a market overshoots to the downside in an “unhealthy” manner, it becomes “unhealthy” for the market to correct this overshoot as quickly as possible? It defies logic. Simple common sense suggests that, if a market reaches extremes to the downside, then it’s “healthy” for the market to correct these excesses as quickly as possible. (To bring the analogy back into its original context, is it “unhealthy” to a gravely ill patient to recover suddenly and quickly?)
This is exactly the kind of recovery that's happened. What’s happened thus far, is the market has merely corrected an oversold condition reflecting “irrational despondence” toward a level that reflects a more rational assessment. And in my view, the speed with which the market corrects excesses is a good indicator of its health and resiliency.
So, if the consensus is as bearish as I suggest, why is the market going up? The answer: Short-term traders are in cash and/or are betting against the market. Long-term institutional money is moving in -- regardless of the personal views of the managers -- for reasons related to how the industry is structured.
It's my view that eventually, the long-term institutional money that needs to get fully invested is going to overwhelm the traders. And soon, these traders will be reversing positions and going long. At that point, the melt-up kicks into full gear.
Add one more: earnings revisions. Historically, earnings revisions have lagged market prices. However, with earnings revisions trending strongly from a low base, this should provide a favorable wind behind the market’s sails for quite a few weeks to come. Many analysts -- in order to gain publicity and redeem themselves from having missed the rally thus far -- will be making dramatic revisions to EPS estimates and target prices. One needs to get out in front of this trend.
How Far Can the Rally Go?
Based on normalized earnings, a “normal” range of valuation for the S&P 500 would be between 950 an 1,350. That means this market has a great deal of room to run before it starts looking “overvalued.”
In any event, valuation isn’t the main factor to look at now. In a strongly trending market, when valuations are within “normal parameters,” valuation becomes a secondary or tertiary consideration.
There are 2 things that matter right now: First, the flow of fundamental news is extremely positive. Second, cash allocations are at all-time highs. As cash starts to move back into equities through institutional mechanisms, there will be virtually nothing that can stop this market.
There’s one main risk that rises above all the others: A precipitous rise in long-term government-bond yields to a level significantly above 4.00%. This would signal a loss of confidence in the ability of the US government to execute its fiscal and monetary stimulus program. I don’t believe that such a development would be fundamentally warranted at the present time. However, this is more a matter of psychology than fundamentals. Thus, it's an unquantifiable risk. If this happens, all bets are off.....
The other major risk to my outlook is the obvious one: I could be wrong.
The market is recovering from an unusual and vicious financial crisis; this is a time in which market participants, after having been petrified, are starting to come to grips with the fact that Great Depression II is probably not going to happen.
This is also an extraordinary time - one in which vast numbers of market participants are wrongly over-allocated to cash. As investors adjust their asset allocations to account for new realities, the rally in financial markets will be extremely powerful.
Indeed, because of the large cash allocations, there’s the danger that at some point, things could get out of hand on the upside. Because of the effects of massive inflows by institutions that invest mechanically and are essentially insensitive to fundamentals, the market could overshoot to the upside, failing to properly account for the risk (as opposed to the certainty) that things could get materially worse in 2010.
However, we’ll worry about the risk of bullish overshoot later. For now, the financial crisis is over. And for now, I believe this market is going higher - much higher.