There has been a plethora of bad news over the last couple months – ISIS (the Islamic State in Iraq and Syria) has struck the world stage (literally), Hamas has lobbed over 2,000 fresh rocket attacks into Israel and Israeli Defense Forces have moved into Gaza, the globe was distracted by The World Cup, a 6.8 earthquake struck off of Fukushima, CitiBank was fined $7 billion in a mortgage probe, the second largest Portuguese bank defaulted, pneumonic plague appeared in Denver, a Malaysian passenger jet was destroyed by a ballistic missile over Ukraine – and still, equity markets are higher, energy stocks (including MLPs) have held up, municipal bonds (munis) remain in high demand, volatility remains extremely low, and taxable bonds are doing okay.
On the face of it, none of this necessarily means that the markets are safer, nor does it mean they are riskier. The Fed’s dovish liquidity reassurances, as well as the European Central Bank’s (ECB’s) rhetoric, have propelled the indices. Even though volatility, as measured by VIX is low, the put-to-call ratio (otherwise known as the SKEW Index) is very high. A high SKEW Index means that the market is not complacent; it means that there is heavy hedging towards downside protection; i.e., significantly more investors are buying ‘puts’ to protect from a decline than are buying ‘calls’ to bet on an increase. We would view any pullback as a healthy development to reset and recalibrate expectations for what should continue to be a secular bull market. But the market could go higher before we see such a recalibration.
On the positive side, it isn’t so much “why are we rallying?” but rather “why wouldn’t we rally?” – economic data is benign (at worst) and showing impressive improvement in other areas like the purchasing managers index (PMI); the Q1 earnings season was okay other than some one-off events and weather issues; Q2 should be much better; M&A volumes continue to build (Allergan, Intercontinental, Hillshire, Time Warner, Direct TV, etc.); central banks remain accommodative (especially the ECB); and U.S. equity valuations are undemanding (PE of 16x for 2014 and sub-15x on 2015 numbers).
You probably don’t remember what you had for lunch last week, but you almost certainly have vivid memories of what happened economically and in the markets during 2007 & 2008 like it was just five minutes ago. You remember the Senate debates, the panicky reactions of the Fed and the FDIC, and the turmoil in the markets as banks and alternative funds disappeared, and ho-hum run-of-the-mill securities suddenly lost their liquidity. This memory of what happened five minutes ago five years ago, still plagues the markets; therefore, it still affects how the US Fed and other central banks, like the ECB, engineer monetary policy going forward.
The Fed is on a careful path to raise rates in the next 12 to 18 months. Yellen is continuing Bernanke’s tradition of signposting Fed moves well in advance and getting the rumor mill running [think Louella Parsons or Perez Hilton] so that monetary moves are well expected and built into pricing assumptions (as best as possible). The Fed is supporting the investment needed for growth through clear guidance that increases in bank rates will be gradual and limited. This is in part because the actual and perceived headwinds facing the economy are likely to take some time to die down.
Expect US growth to pick up. The end of deleveraging (both public and private-sector), pent up demand for housing, cars and capex, together with the sharp decline in the real US dollar index should support a return to solid, sustained GDP growth. The Federal Reserve will continue to ‘taper’ QE, but will work hard to demonstrate its commitment to zero interest rates into 2015.
Michael Ashley Schulman, CFA
Hollencrest Capital Management