But what if 2013 is the year in which fear fades from the backdrop? What if system risk in Europe dissolves, the U.S avoids a major debt ceiling fallout, and confidence returns to markets? What if CEOs start spending again, and retail investors trade in all that money parked in very low yielding bond funds for stocks? In short, what if this is the year where fear is replaced by greed? Improving confidence, diminishing fear, and huge amounts of liquidity could lead to a blow off overshoot to the upside in equities.
So far it looks like fear is indeed fading from the investment scene. It’s been a robust year in equity markets, with the domestic markets now up about 15%. Europe has had a few setbacks, but nothing like prior years. The fiscal cliff and debt ceiling have receded to the background and folks seemed to be piling into yield based stocks as they weigh the relative value between stocks and bonds. CEOs haven’t started spending yet, but global liquidity and central bank activism have more than made up for the current lack of capital spending. With the chase for equity returns heating up, one wonders how high this could go? We’re not entirely sure ourselves, but we’re keeping an open mind. The current environment of suppressed system risk, slow growth, and buoyant liquidity might take this up market farther than most think.
Just for fun, I’ll take a guess (and it is only a guess) at how high the market will go before it peters out. A 15 multiple on forward earnings would take the S&P 500 a little north of 1700. If the market achieves 1700, it would be about a 62% rally off the October 2011 bottom, and if it happened by the end of the second quarter the rally would span 600 calendar days. That would be close to the average cyclical bull market within a secular bear, which according to Ned Davis averages 66% in gains and 523 calendar days in duration. Of course, some think we’re now in a secular bull; if that’s the case the Ned numbers for those regimes are gains of up to 110% and over 1000 days in duration. We remain unconvinced that we’re out of the secular bear regime, though we’re also open to the fact that secular forces for stocks may have changed for the better.
Of course, this is all just a guestimate of where we could go if the current scenario continues to play out — this view does not drive our allocations. As risk managers in a low conviction market, we recognize that the high liquidity environment driving assets north does not come without big risks and unintended consequences attached. Our investment process tells us it’s getting late in both the business and market cycles; this is not a time to load up on risk. Despite my guess that the market could continue to confound by climbing higher, our weight of the evidence approach has us tucked close to benchmark levels of volatility, and utilizing sector and industry rotation to try to garner portfolio alpha. We’re riding enough of the market to make sure we participate in the liquidity wave while it exists, but we’re also watching for divergences that could be signs of a market top.
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