In spite of an increase in daily volatility the stock market has been stuck in a tight trading range this year. There has been a lot of huffing and puffing with markets going nowhere until very recently. Many stock indices were down for the quarter, some only positive due to their dividends and have returned less than 2% in 2015. The biggest action was a reversal in interest rates as investors anticipated the Fed raising interest rates later this year. However, world economy growth is already tepid with global purchasing index for manufacturing dropping to 51 a neural reading. A sluggish economy should keep a firm bid under Treasuries and their haven status makes them a good choice over cash, especially given the uncertainty over Greece.
Despite the placidity of the market in the quarter there is some volatility beneath the surface. About a fifth of all stocks have suffered a drop of at least 20% from their highs, many of them dividend paying stocks. Value is out of favor as seen in the 125 lowest Price to Earnings stocks in the S&P 500, at the beginning of the year, underperforming the rest. The opposite was true for the most expensive. Because growth is so scarce, investors are bidding up any company with growth regardless of valuation. The real nuttiness is in private markets. The car-hailing platform, Uber, raised a new round of money at a $50 billion valuation up from a $41 billion valuation just six months ago.
There are many ways to value the stock market and most confirm that prices are at or near full value. Past market tops have often come when global market capitalization roughly equals global GDP. Global market capitalization topped GDP in 1999 during the dot-com bubble and again during 2006-2007, before the financial crisis. Today the International Monetary Fund (IMF) estimates global GDP at $74.5 trillion which approximately matches global market capitalization. Like the other episodes it doesn't mean prices are ready to fall but it clearly suggests risks are elevated.
The path the stock market will take over the next few years is unknown, and we've often argued that short-term movements are random, but here is an interesting observation from Barron's that points out the correlation between the stock market and the size of the Fed's balance sheet: "Of course, the stock market has moved up pretty much in tandem with that balance sheet from its March 2009 lows when the Fed stepped up its securities purchases. Since then, the U.S. stock market’s value has increased 226%, or some $18.6 trillion, according to Wilshire Associates. And since the announcement of the second phase, or QE2, in August 2010, stocks have added 104%, or $13.1 trillion. And since September 2012, when the launch of QE3 was revealed, U.S. stocks are up 49%, or $8.4 trillion. More recently, the Fed’s balance sheet has stopped growing and actually has shrunk slightly in the past five months. Viewed from the perspective of the Fed’s balance sheet rather than interest rates, the tightening has started. And in this bull market, the course of the averages has been set by the balance sheet." (emphasis added)
However, there are some good reasons why stock prices remain elevated and could even move higher. For instance, high yielding stocks look attractive for income. Recent economic data has been decent as well. The unemployment rate is down to 5.3%. Total household debt is around 107% of disposable income, with annual payments taking up less than 10% of disposable income, the lowest amount since at least 1980. Household net worth is at a record high in real terms, and is close to its pre-crisis peak as a share of GDP. And while the Fed is set to raise interest rates from basically zero they have signaled that the pace of tightening will be slow.
The following reporting from The Economist highlights the unique environment we are operating in today: "The IMF is dovish. In a review published on May 28th its economists recommended that unless there is new evidence of strong wage- or price-inflation, interest rates should not be raised until early 2016. The Bank for International Settlements, a central-banking body based in Basel, takes a different view. Its economists worry that low rates lead to asset-price bubbles, and suggest that it would be wise to start tightening as soon as possible before such bubbles are further inflated by cheap money." These two international organizations employ the best and brightest economists in the world yet their recommendations to the Fed are polar opposites. We are truly in uncharted waters.
We strongly believe that now is not the time to take a lot of risk and have recently allocated accordingly. At some point in the future stocks will offer double-digit growth. But until then patience is needed. We are currently in a low return environment. Trying to find high returns rather than being patient is usually met with negative consequences.