As a bottoms-up manager, I tend to make capital allocation decisions without regard to the macro environment. However, I do keep one eye on emerging trends to the extent that they might provide me opportunities to take contrarian positions. My firm tends to maintain a fairly balanced book, but we will skew towards a long or short bias if we have strong conviction about the level of equity prices one way or another.
There are always several theories for major market moves. Some are relevant, some are nonsensical. The recent bull run is no different. There have been two prevailing explanations for the current run up in asset prices: the growing traction of the recovery, and the prospect of more easing from the Fed. I will assess these two explanations and will conclude with a discussion of the current level of asset prices.
The "genuine recovery is taking hold" argument does not stand up to any serious scrutiny. It is no secret that economic growth in the US (and around the world) has moderated over the past several quarters, and the effects of fiscal stimulus are wearing off as the appetite for austerity increases. Since the US government counts one dollar of spending as one dollar of GDP, the stimulus funds were bound to boost reported GDP regardless of where they were directed. Now that the spending has peaked, the stimulus will be a drag on reported growth going forward. The partisan bickering over the effects of the stimulus will continue, but no one can honestly claim that we are in a robust recovery. Unemployment remains depressingly high, and it doesn't seem that there is anything on the near-term horizon to meaningfully change this.
It seems much more plausible that the prospect of additional quantitative easing from the Fed (hereafter, "money-printing") is the cause of the recent surge in asset prices. For proof of this, we need look no further than the entrenched inverse relationship between the dollar and the S&P 500, a correlation which has grown even stronger recently. Since the beginning of September, the S&P 500 is up about 13%. During that same time, the Euro is up about 10% versus the dollar. This relationship is roughly the same between the US dollar and other major currencies. If you are a non-US investor, you have made little (or no) money holding US equities during the last 7-8 weeks. This is not what we would expect to observe if we were in the midst of a genuine recovery.
We must then assess what the effects of QE/money-printing are likely to be. As much as I'd like to believe that the next round of securities purchases from the Fed will spark growth, I cannot arrive at this conclusion while remaining faithful to reason. Interest rates are already extremely low, so it is hard to imagine a stimulative effect from a further reduction in borrowing costs. The money that the Fed prints will find its way into the hands of firms who have no obligation to invest their cash in the US. This money will seek the highest possible returns. If I had to wager a guess, I would say that it continues to flow into emerging markets, many of which are already coping with too much hot money.
Perhaps the Fed thinks it can drive domestic equity prices high enough to trigger a wealth effect that will get consumers to open their wallets once again. This theory is dubious at best. Individual investors have been fleeing from the capital markets because of overwhelming mistrust. Estimates vary, but suffice it to say that a significant portion of daily trading volume is the result of high frequency trading firms buying and selling from and to each other. For these reasons, a continued rise in equity prices is unlikely to line the pockets of American consumers in the way the Fed seems to hope it will.
So what does this all mean for the current level of equity prices? As detailed above, the chances seem slim that a genuinely strong self-sustaining recovery will take hold in the near-term. This is bad for stock bulls. The prospect of more money-printing has already driven asset prices up. Though this discussion has focused on stocks, many commodities are up even more than equities over the past few months (and, no, I'm not talking just about gold). Additional money-printing will be supportive of high commodity prices. The effects of high pricing will manifest themselves in one of two ways. If companies find that they cannot pass input prices through to weak consumers, they will have to bear the brunt of the high prices themselves, leading to shrinking margins. This is bad for stock bulls. If companies find that they can pass on higher input prices, consumers will have to engage in further belt-tightening. This is bad for stock bulls. If the Fed is unable to spark recovery while it drives up commodity prices, public outcries against the central bank will grow to deafening (to the extent that they aren't already there). Though it likes to present itself as an independently thinking body, the Fed will be unlikely to engage in QE3 if QE2 goes as I expect it to.
As I said at the outset, my firm is currently running a fairly balanced book. However, each time stocks rally, there emerge more short opportunities, and the bear case is stronger than the bull case at present. Any bargains that my firm saw a few months ago are gone now. We are likely to add more short exposure than long in the coming weeks, but, as always, we will adjust our strategy in the face of market developments.
Disclosure: N/A
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