One of the amusing things right now is that there isn’t much debate in equity-land as to whether to be long or not. The prevailing sentiment is you gotta stay the course until the fat lady sings, or at least clears her throat, in the form of the Fed saying it will really, finally, for sure, start the taper. And of course the Fed wants to have its cake and eat it too. The central bank, in the possession of overwhelming evidence that QE is not doing much for the real economy, very much would like to exit QE but without deflating asset prices. So it hopes that repeatedly insisting that it has absolutely no intent of raising interest rates any time soon will be sufficient to placate the Bond Gods and their drinking buddy, Mr. Market.
So for the most part, the talk among investors is various reading of fundamentals or technicals or historical parallels to justify staying invested in stocks. Now juxtaposed with that, you do find some bona fide skeptical commentary, such as Lombard Street note, Party like it’s 1999 (FT Alphaville via MacroBusiness)
Similarly, George Magnus, former chief economist of UBS who was widely recognized as an astute commentator in the runup to the crisis, gave a good overview in the Financial Times yesterday as to the logic for the bulls’ case: Equity bulls trust in the Fed, not the economy Key points:
The capitulation of market sceptics in the past several weeks has not been pretty. But it was perhaps inevitable, and so, as we look to 2014, the consensus among market strategists has hardened.
The Federal Reserve is expected to start tapering asset purchases in the first quarter of next year, if not sooner, but investors should keep the faith, and remain committed to the near five-year-old bull market in equities…
Looking back over the past year, almost three-quarters of the rise in global equity returns came from the re-rating of price-to-earnings ratios, which are now touching a long-run average (ex-technology bubble) of around 15, which is what they did in the 2009-10 rally, before trending down again until 2012.
The cheerleaders argue next year we will get upside earnings surprises, from an acceleration in global growth, higher capital spending by cash-rich large companies and rising operational leverage as margins increase. We could even get higher p/e ratios because the abnormalities of the 2008-13 period, including the financial crisis, recession, deleveraging and euro-break-up threat, are now history. Instead of the narrow 10-15 range for p/e ratios that describes most of the past six years, why not the more “normal” 12-25 range of the past quarter century?
For these things to happen, though, two propositions must hold. First, global growth has to accelerate, and become self-sustaining, and second, the “bad cycle” of 2008-13 must really be over, leaving no detritus behind. Neither stands up to scrutiny. The former is fickle, while the latter is fantasy.
Now with the central banks’ super cheap money, by design, driving investors into riskier assets, talk of fundamentals seems, well, antique. But behaviorally, something a smidge more complicate is going on.
Superficially, this is all typical late bull market/bubble behavior. Even if investors think valuations are strained and downside risks aren’t trivial, they are reluctant to leave the party early, since they get punished for lagging their comparable group. So as Keynes said, it’s better to be ruined in a conventional manner. Their incentives are that it’s actually better for them to stay in too long and get crushed in the rush for the exit, so long as they can succeed in getting no worse stomped on than their colleagues.
The second factor that leads them to risk overstaying was described by reader Scott. No investor can afford to admit to their clients that the Fed is dictating their strategy. They all have spiels generally of the form of how they do serious analysis of some sort to come up with their particular picks. They therefore need to craft a description of current conditions that makes them being long make sense given how they profess to invest.
I posit that in a lot of cases, they become victims of their own PR. Studies have found that lawyers who are defending a client they believe to be guilty increasing come to think their client might be or actually is innocent. Advocating his case leads them to come to believe his case.
But in the short term, unless we have an unexpected geopolitical event, Mr. Market does not seem to face any imminent threat to his health. Given how the Fed lost its nerve on starting the taper over the summer, I can’t imagine that the improvement in economic data, such as it is, is sufficient to give them the nerve to pull the trigger this week. If I were them, I’d wait to see how the critically important Christmas season panned out before making any decision. So most professional investors will be probably be able to ride out the end of the year without any holiday season high drama, except the sort generated by family dysfunction.