Roughly a year ago I found myself on Larry Kudlow’s show defending a bullish position in U.S. equities and a bearish position on bonds. The S&P was under 1,300 and the 10-year note had a yield under 1.6 percent. I said we could see the S&P get to the 1,700 level (maybe 1,750) and the 10-year would get over 2.5 percent. A gutsy call considering the dysfunction out of Washington and fears about a European breakup.
My thesis was simple: Failure was, and is, no option for the Europeans: The contraction in the multiple to earnings was a direct result of the lack of pro-growth policies coming out of D.C. The fixed income market was a parking spot for the capital which would eventually be reallocated back into riskier assets, namely stocks. But the market realized something after the last election… President Obama is now a lame duck. It’s one of the main reasons why we have seen an expansion of the multiple back to the norm. Rates have moved back up comfortably and Europe surprised everyone. However we now have a problem…The market has become fairly priced.
One of the other important variables I watch is the notional value of the stock market verses that of the entire U.S. GDP. Except for two times, equities have historically traded at a discount to GDP for the last 50 years. Unfortunately, both times were followed by a serious correction. The time has come to say that the ‘easy’ money in equities might be behind us unless we see real growth in the GDP numbers and forecasts increase for top line revenue from corporate America over the next couple years.
I had a mentor, Dr. Bing Sung, from Harvard who told me one day we could see a paradigm shift in the pricing of equities to GDP as a direct result of the winning of the ideological cold war. Could this be it? Since we are more global in nature, should we be looking at GNP which encompasses revenue abroad and is a much higher number? The market has tried to invert that relationship twice unsuccessfully in the last 15 years. Could the third time be the charm? I honestly don’t know the answer to these questions.
I do know that we have caught an amazing run in stocks and the time to be very careful is upon us. There is an old saying from the floor of the exchange which I was made to memorize as a young trader, “There are Bulls, Bears and Pigs…Pigs get slaughtered!”
One more side note: Don’t look for any tapering until Q1 of 2014 after Bernanke steps down. Incidentally, the last two times we have changed a Fed chairman, the stock market experienced major corrections. Hopefully the third time will be the charm and we can shake off that fear.
This is an edited version of a post that ran on The Jack B Show website.