The Dow Jones Industrial Average and the S&P 500 again reached all-time highs on June 20th and have appreciated year-to-date 2.0% and 6.1%, respectively. Despite the recent market strength, these new highs remain unconfirmed by the broader Nasdaq Composite and Russell 2000 market averages, which remain below their March 6th highs. This three-month divergence is typically a good warning sign that the bull market is in its final stage.
In addition to the underperformance by the secondary market indices, the Dow Jones Industrial Average has averaged a 10% correction every twelve months since 1896. The current bull market has not had a 10% correction since August 2011--34 months ago. While many bulls may believe that the market's lack of a correction in almost three years is a positive sign, we believe the lack of volatility--probably the result of the Fed's QE programs--is unhealthy, leads to excessive speculation, leverage and misallocations of capital. In our view, the excesses that have accumulated, due to the lack of normal corrections, will manifest in a larger, more volatile bear market in the future.
Despite the marginal new highs in the major averages, we continue to believe the stock market offers an extremely poor risk-reward, is poised to provide below-average, long-run prospective returns and is vulnerable to a significant decline (30% or more). We believe many investors have become over-confident and/or complacent despite extreme valuations, disappointing economic growth, increasing inflation and the end of the Fed's asset buying program.
Our top-down outlook remains cautious due to the following factors:
- Long-term valuation measures indicate stocks are overvalued by at least 30%
- Historically high profit margins are poised to regress to the mean and yield disappointing earnings
- The economy and normalized profit growth remain sluggish and near recessionary levels
- Investors are too optimistic and many asset classes show signs of excessive speculation
- Risk assets will be vulnerable as the Fed shifts its monetary strategy from buying assets (Quantitative Easing) to providing forward guidance
The best way to compound wealth over time is to avoid major losses. In our view, the current market cycle is mature and stocks offer an inadequate risk-reward. To mitigate risk, we have reduced our equity exposure, increased asset diversification (cash, bonds and gold), and are managing portfolio volatility. We have used the recent equity market strength to increase our safe asset exposure (aggregate bonds, TIPS, and gold). This increased exposure to low (or negatively) correlated, safe assets should hedge our equity exposure if economic growth is weaker and/or inflation is stronger than the current sanguine economic expectations of strong growth and low inflation.
Our asset allocation remains balanced and focused on capital preservation:
Market Commentary
Our investment thesis remains that the Fed's QE asset buying program, coupled with excessive speculation, have caused the financial markets to decouple from the weak economy, while driving equities to all-time highs and historic levels of overvaluation. This market strength and lack of volatility--due to the excess liquidity provided by the QE program--have convinced many investors and market commentators that risks are diminished and the economy is ready to finally accelerate. In our view, QE, at best, has not helped the economy, but has artificially inflated asset prices to unrealistic levels.
Fed's Monetary Base Relative to the S&P 500
Implied Volatility (VIX) is Near Historic Lows
Investors Intelligence Survey: Bulls at a record 62%, while Bears are only 17%
Larger Image - Source: Investors Intelligence and StockCharts.com
NYSE Margin Debt is at Historic Levels though Starting to Decline
Larger Image - Source: dshort.com
Valuation Levels have only been Higher at the Peak of the 2000 Bubble
Larger Image - Source: Vector Grader
We believe that as the Fed continues to taper its QE asset buying program--expected to end this fall--equities will be vulnerable, as valuations regress to the mean and the markets are once again driven by the fundamentals, not the excess liquidity created by the Fed. In fact, we expect a significant correction (15% or greater) by this fall, as the QE asset buying program ends and the rate of liquidity growth diminishes.
The last two times a QE program ended, the market declined (and there hasn't been a 10% correction since Operation Twist and QE3 began in September 2011):
- S&P 500 declined 17% after QE1 (December 2008 through March 2010)
- S&P 500 declined 21% after QE2 (November 2010 through June 2011)
While the Dow Jones Industrial Average and the S&P 500 reached all-time highs on June 20th, the three-month divergence between the S&P 500 and the small cap Russell 2000 indices, coupled with the end of QE, increase our conviction that the five-year bull market is mature and vulnerable to a significant correction, or the beginning of a bear market by this fall.
The R2000 has not Confirmed the New High in the S&P 500
While we expect a significant correction later this year, whether or not the correction evolves into a bear market (decline of 20% or more) will depend on if the economy and inflation perform as the bulls expect. If inflation accelerates (currently, the Consumer Price Index is 2.14% and the Producer Price Index is 2.45%) or the economy continues to disappoint, equities could be vulnerable to a bear market given the excessive valuation, ebullient sentiment, declining liquidity and weak fundamentals.
While most investment strategists blame the weak first quarter on winter weather, and now expect dramatic 3.5% growth for the remainder of the year, we remain concerned. Bank of America now estimates that Q1 growth declined by 1.9%. Even if Q2 bounces back to a 4% growth rate (unlikely, in our view), the first half of 2014 will have grown at a near recessionary 1%. We find this weakness difficult to ignore, and recent disappointing economic data (housing, retail sales, and trade) only adds to our concern.
Historically, the yield curve has been one of the best economic indicators. While the yield curve remains steep, due to the Fed's zero interest rate policy, it has been flattening for the past six months, indicating weaker growth. This indicator is not consistent with the bullish expectation of a sharp economic acceleration.
In our view, the bull's optimistic economic forecasts will not be met until we have a stable currency, address the structural imbalances and implement pro-growth, supply-side policies. Six years of Keynesian demand-side policies (artificially low interest rates, debase the currency, deficit spend and increase taxes) have prevented our economy from attaining normal growth and improving living standards. Ultimately, these Keynesian policies will lead to stagflation--weak growth with high inflation--as they did in the 1970s.
In conclusion
We believe the five-year global bull market is ending and risk assets offer a very poor risk-reward as interest rates, profit margins and valuation levels are poised to "regress to the mean." We believe a portfolio balanced for any economic environment (growth, recession, inflation, deflation) is essential, given the extreme equity valuation, weak economic growth, and the inflationary risk due to the Fed's (and other central banks') money-printing experiment.
Our core philosophy is that the best way to grow wealth is to have a long-term investment horizon and avoid major losses. Because profitability levels and growth regress to the mean over time, valuation is the best measure of long-run prospective returns. Currently, the equity markets are overvalued and offer a very poor risk-reward. We believe investors should reduce their exposure to risky assets and be patient until the risk-reward improves and investors are adequately rewarded for assuming equity risk. Historically, liquidity-driven bull markets deflate quickly and patient investors will be rewarded with great values and significant long-term opportunities.
