Stocks
The stock market has responded to QE3 with a very strong rally since last November. The announcement by the Bank of Japan that it will double its monetary base over the next two years to reverse the grip of deflation that has depressed the Japanese economy for most of the past 17 years has made investors more optimistic. Investors have revised the old adage of ‘Don’t fight the Fed‘ to ‘Don’t fight the Fed, ECB, and Bank of Japan‘. In the latest Barron’s Big Money Poll, 74% of the money managers who responded described themselves as bullish or very bullish for the balance of 2013. This is the highest percent of bulls since Barron’s began doing its Big Money Poll 20 years ago. Over the next twelve months, 86% are optimistic, while 94% think the next five years will be good. For perspective, only 54% of money managers were bullish as the market was forming its top in 2000. As we have often stated, markets don’t top because there are too many bulls. Markets top when investors are given a reason to sell. Since the consensus is for earnings and the economy to accelerate in the second half of 2013, investors may be disappointed if the economy fails to pick up speed by year end as we expect. Beyond the belief QE3 effectively immunizes the stock market from a decline, money managers also believe bonds are unattractive and the U.S. looks good when compared to most markets around the world. This theme has gained enough traction to acquire an acronym – TINA -there is no alternative. This has a familiar ring to it, i.e. technology stocks as the New Paradigm in 2000 and in 2006 the belief that home prices could only go up.
While monetary policy is boosting the stock market, the economy isn’t responding as it has in the past. This creates a potential risk for the stock market should valuations get too stretched. Most analysts cite the standard price earnings ratio as indicating the stock market is fairly valued since the current P/E is about 15. Since we live in extraordinary times we’re not sure a standard measure of valuation is entirely appropriate. The Q-ratio was developed by Nobel Laureate James Tobin in 1968. The Q-ratio is the total price of the stock market divided by the replacement cost of all its companies. The average since 1900 has been 0.7 and readings above 1.00 have been rare and significant: 1906 1.08 – 1929 1.06 – 1938 1.08 – 1968 1.04 – 2000 1.78, September 30, 2012 1.00. The S&P has rallied more than 9% since the end of the third quarter, and the Vanguard Total Market index is up 10.2%. This suggests the Q ratio is likely nearing prior market peaks, with the exception of the 2000 dot-com bubble market. Technically, the S&P 500 is testing an important trend line which connects the highs in 2000 and 2007. The overall formation since 1999 is potentially a broadening top which looks like a megaphone. It is certainly possible that QE3 will enable the S&P to break out above 1,600, which could lead to a blow off that carries the S&P to 1,680 – 1,700. Since we think the Fed will maintain QE3 for the rest of this year, the bullish psychology surrounding QE3 makes this a real possibility. But a significant rise from here will only widen the divergence between the market’s valuation and the performance of the economy, at a time when faith in the Federal Reserve has never been higher. This increases the risk that ‘Don’t fight the Fed’ could become the ultimate blind spot.
We noted last month that a 5 step rally in the S&P 500 from the November low was nearing an end, which suggested that the market was within 1%-2% of an intermediate high. On April 11, the S&P made an intra-day high of 1597.35. A decline below 1,536 would increase the odds that the April 11 high did mark an intermediate high. That said any correction is likely to find support near 1,485 – 1,510, since investors have few reasons to sell and are looking to buy the dips. The market could be more vulnerable during the second half of this year if the anticipated acceleration fails to materialize. Since the low in March 2009, every intermediate low has been higher, so any decline below 1,485 would be an important negative and increase the odds that the S&P had made a triple top on April 11.
