16 July 2014

Macro Strategy Update

Don't Worry, Be Happy

Executive Summary: We find the case for a secular bull market especially for US equities compelling as there are several reasons like productivity, earnings margin and technology driving corporate profits. We are also mindful that some risks remain and that valuations for most markets are fair and that longer term returns could be more subdued. As such, we continue to prefer equities but will remain tactically nimble should the market suffer a shock.

Portfolio Positions: We are currently at a neutral asset allocation with a bias to developed markets. Should there be further promising signs from emerging markets, we will look for an opportunity to take a position for some of our portfolios.

Article

Introduction
A musician named Bobby McFerrin released the song “Don’t Worry, Be Happy” in late 1988, which was based on a famous quote by Indian mystic and sage, Meher Baba. We’d also advocate the same to our investors. Recently, there have been a host of differing opinions about how markets, especially for US equities, would pan out for the rest of the year. On one hand, there has been a growing chorus of calls for a secular bull market, whilst others have been warning about growing complacency and excessive risk taking amidst the low volatility environment. Let’s examine the data to see which story is more likely.

Start of the Secular Bull
By definition, a secular bull market is driven by forces that could be in place for many years, causing stock prices to rise over a long period of time as a result of strong investor sentiment. These forces largely revolve around the economy: growth and inflation. Today, after the S&P500 rallied 26% from the October 2007 peak, more market technicians are calling for a secular bull market, purely from the price action. The breakout above the peaks of March 2000 and October 2007 represents an important trend change (Fig 1). Secular bull markets are usually born out of lost decades, and based on historical evidence, stocks typically enter a long period of expansion after emerging from a period of negative 10-year holding period returns (Fig 2 and 3).

Image courtesy of Stockcharts.com

Fig 1. US Equities Breaking Out of 10-Year Trading Range

Fig 2. Falling Valuations During “Lost” Decades

Fig 3. Secular Bull Markets After “Lost” Decades

Sustainability of the Run
Various reasons point to why the run can continue. Productivity increases in the US economy, owing to reduced energy cost and technological improvement is an important driver. The ability to squeeze out additional profits is a key characteristic of American companies. The shale gas boom, which we have written about previously, continues to play a long term role in supporting the domestic economy with lower energy cost. More importantly, the global energy market has matured as supply increased and demand from developing economies slowed. US energy production has come to a point where rapid growth is expected and the US could achieve energy self-sufficiency in the near future (Fig 4).

Fig 4. Total Energy Production and Consumption in US 1980-2040

Productivity is Key
Improved productivity is also likely to come from the increased use of technology, ranging from cloud computing to robotics. Academics have published research about the benefits of technology but the general trend is clear: businesses can do more at a lower cost by leveraging technology. This is why corporate profits have been rising despite a tepid economic recovery (Fig 5).

Fig 5: Corporate profits surpassed previous cycle

Lukewarm Inflation
Benign future inflation allows central banks to focus on employment, thereby keeping monetary policy loose and interest rates lower than previous cycles. The Fed’s bond buying program, contrary to popular opinion of money printing, did not unleash uncontrollable inflation as feared by some. Instead, while interest rates were held low, credit growth remain subdued (Fig 6). Another measure of how high inflation could potentially go is the velocity of money (Fig 7), which has fallen tremendously. Coupled with the fact that bank regulation has increased and the high level of indebtedness in the economy, future credit is unlikely to grow like previous cycles. As such, the much feared hyperinflation is unlikely to materialize and gives the Fed leeway to keep interest rates low in an effort to keep the job market humming. Low inflation and interest rates are favourable factors for expanding equity valuations.

Fig 6: It will be a long while before credit recovers

Fig 7: How fast money changes hand has slowed tremendously

End of QE is Not the End
The end of QE did not cause a collapse in asset prices and there are many commentators who believe that the Fed’s bond buying programs are the sole support of risk assets. After all, with real interest rates in negative territory, investors are forced into higher risk assets like equities to preserve the value of their wealth. Now that QE is set to end come October, many expect a decline in the stock market. However, we view it as unlikely. Back in the 1950s when the Fed stopped their bond buying program, interest rates rose but so did stocks.

Complacency in the Market
Much has been said in the financial media about the current low market volatility and its related concerns. For one, a long period of low volatility could in fact lead investors to start taking undue risk leading to assets bubbles. However, we see that the fundamental data is supportive of the market as a whole, and volatility in the past has been much lower and is not at extreme levels (Fig 8).

Fig 8: Current Volatility Whilst Low, Is Not At Extreme Levels Just Yet

Exuberance and Retail Participation
What about exuberance in the market? Is everyone including your neighbour jumping into stocks at this point in time? One good sign of a market top is the irrational exuberance exhibited by the everyday investor. Whilst surveys may show otherwise, looking at real money flows will give us insights, and it shows that participation is still relatively low and that individual investors continue to remain cautious. In fact, reading the news about warnings of overvalued markets is a sure sign that bullish sentiment is not at a peak yet (Fig 9).

Fig 9: Equity Fund Flows Data Since 1997

Conclusion

With all these in mind, we view markets currently as fair value. Earnings will be important to keep driving the market forward, and with the US economy moving forward at a decent pace, the growth we are looking for should come through. If the US stock market is in a secular bull market, then our investment strategies should adapt accordingly. Market dips should be bought and corrections not feared. High valuations should not be viewed negatively but be seen as a confirmation that investor sentiment is improving. However, we are keeping a watchful eye out on whether earnings disappointment or a possible outlying geopolitical event could cause a shock to the markets. Our portfolios reflect our view – we prefer equities but are mindful of valuation and potential risks. As such, we are currently at a neutral asset allocation with a bias to developed markets. Should there be further promising signs from emerging markets, we will look for an opportunity to take a position for some of our portfolios.



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