Jurrien Timmer, director of Global Macro, and co-manager of Fidelity Global Strategies Fund, writes about the recent equities rally seen globally and whether investors should hold, buy more or sell stocks. The article first appeared on Morningstar.com, our US sister site.
What to make of the stock market these days? Do we buy, hold, or sell? The market has been rallying sharply since last October and has been on a tear so far this year. Yet the tail risks loom as large as ever. While there has been a lot more positive news on the U.S. economy lately, the tails (Greece, Iran, and China) are so "fat" that any one of them could derail the rally.
How do we invest in the midst of all this existential uncertainty? How much risk is appropriate in a portfolio? After such a strong rally, how high is our conviction that it can continue? Is it time to derisk our portfolio, or should we stay fully invested? In order to answer these questions, let's review what the market has going for it and what it doesn't.
Improving U.S. economy
The good news is that the U.S. economy--in fact, even the global economy--seems to be getting better. Jobless claims, non-farm payrolls, and the PMI (Purchasing Managers Index) surveys from around the world have been improving in recent months, pushing the stock market higher. In fact, the S&P 500® Index has rallied 26%--from a low of 1,075 on October 4, 2011, to a high of 1,354 on February 6, 2012.
Clearly, the news has been positive--so positive, in fact, that the Citigroup Economic Surprise Index (CESI) has completely round-tripped from the lowest levels in years to the highest levels in years. This index measures economic data against their estimates, so when the data exceed the estimates, the index rises, and vice versa. The index tends to be positively correlated to both the S&P 500® Index (it's a three-month rate of change) and the 10-year Treasury yield. You can see in the chart below that the CESI looks a bit toppy here, which suggests that stocks may not have much room left to run without another catalyst.
As for Treasuries, it is interesting that yields have not risen in line with the CESI in recent months. According to this indicator, the 10-year note should be at 5%! In my view, this raises the question as to whether long-term Treasuries are overvalued relative to the economy's strength. It is hard to know whether this low yield is a result of the Fed's ZIRP (zero interest rate policy), which is manipulating the yield curve lower, or just disbelief among bond investors that the economy is indeed gaining traction. Either way, we need to carefully consider whether Treasuries still offer a compelling value proposition at these low yields, given their recent divergence from the stronger economic data.
The ECB comes to the rescue
Central banks had a lot to do with this rally, especially the European Central Bank (ECB), which conducted a very successful game-changing three-year LTRO (Long Term Refinancing Operation) back in December. The fact that Europe's struggling banks could fund themselves with 1% money for three years effectively took the risk of a Lehman-like bank failure off the table, and lifted the cloud of doom that had been hanging over the market. When the banks rally, the stock market rallies, because in Europe the banks are the lifeblood of the economy.
In a few weeks, there will be a second LTRO, again at three years and at a 1% interest rate. Expectations are high that the take-up from the banks will be very large, possibly even €1 trillion, part of which will be used to buy sovereign debt. If that happens, it could kill two birds with one stone for the ECB. Why? Because the ECB is more than willing to provide liquidity to the banks (as the LTRO shows), but it is adamant that it will not directly fund sovereign debt. But if the banks take the ECB's cheap liquidity and buy sovereign debt, then the effect is the same. In that regard, the ECB could be accused of (or commended for, depending on your point of view) providing quantitative easing (QE) to Europe's peripheral countries—only instead of the ECB's buying the debt directly, it uses the banks as a conduit. Either way, it relieves stress in the financial system, which is bullish for risk assets.
The question now is: How much of this bullish effect is already reflected in the market? After all, everyone now knows how successful the first LTRO was and that the second is coming up shortly. My sense is that sovereign risk spreads (i.e., the yield spread between a country like Italy and a "safe" country like Germany) have narrowed sharply in recent weeks, in part because of this anticipation that the next LTRO will be really big. Call it a form of frontrunning the expected ECB action. As a result, I am more inclined to reduce risk into any rally leading up to or following the next LTRO. "Buy the rumor, sell the news," as they say.
The Fed commits to short-term rates
More recently, the Fed joined the party by committing to keeping short-term rates near zero out to late 2014 (previously it was to mid-2013). While QE3 remains a distant hope for many bulls, the even stronger commitment to ZIRP was certainly welcomed.
Investors are optimistic
The strength in stocks since the October low has been further helped by the fact that investor sentiment had reached very depressed levels last summer and is only now catching up in a meaningful way. For instance, the ISI Hedge Fund Survey shows that as recently as December, hedge funds were as net short as they had been at the March 2009 bottom (following a 57% decline), with a net exposure of only 42 (50 is neutral). Hedge funds have been scrambling ever since to cover shorts, but even now (as of February 10, 2012) the survey is only at 46.7, which is still net short. Other sentiment surveys are now showing significantly more optimism.
This underexposure to risk assets in recent months has been an important contributing factor to the rally in risk assets (and one that got me bullish last September), but we are now reaching the point where this is becoming less and less of a factor. So it's still a marginal positive, but not nearly as big as it had been.
Credit has rallied
It isn't just stocks that have rallied, but all risk assets have joined in, especially credit. For instance, the JP Morgan High Yield Corporate Spread Index has narrowed from 864 bps last summer to about 600 bps, and the S&P/LSTA Leveraged Loan Index, which measures bank loans, has rallied from 88 cents (on the dollar) to 94, both as of February 10, 2012. These have been among my favorite asset classes.
This strength highlights the convergence that has been taking place among investors into corporate bonds. Bond investors have been moving up the risk curve in search of more yield, while equity investors have been moving down the risk curve in search of less volatility. The intersection is the credit markets. This is a powerful trend that could last a long time, but my conviction is not as high as it was six months ago, simply because credit spreads have come in so much.
Greece is still problematic
Greece remains at risk of a disorderly default. Its debt continues to trade near 20 cents and we are still waiting for a PSI (private sector involvement) deal. Greece has a €14.5 billion debt payment due on March 20, so it needs to come up with something soon. The Greek Parliament recently passed the latest austerity measure, but that is by no means enough to seal the deal. Needless to say, the inability to reach a deal soon could be highly problematic for risk assets. A disorderly default could adversely impact the ECB's balance sheet (which holds tens of billions in Greek paper), and it could trigger CDS (credit default swaps). It could even lead to a Greek exit from the euro.
I believe that investors have gotten somewhat complacent about Greece, thinking that it is too small to matter and that policymakers will figure something out. While it is certainly true that Greece is small in terms of its economy, the risk of contagion is not, despite the ECB's best efforts. What happens to Portugal after Greece defaults and possibly leaves the euro? Will it want to do the same? How about Italy?
There is no question that Greece and other peripheral countries in Europe are in an untenable debt spiral, and while the ECB can flood the system with liquidity, it can't make countries solvent (other than by monetizing their debt, which it claims it can't and won't do).
China is a wild card
China remains a complete wild card. The Chinese economy has been slowing down, which was the government's intention in order to bring inflation down. Now the question is whether Chinese policymakers can engineer a soft landing or whether it will suffer a hard landing, which in turn could have a ripple effect on the rest of the world. China is exceptionally hard to figure out, in part because it is such a controlled economy (where a few people make most of the decisions) and in part because the data are difficult to interpret. So, we have to assume that it will be a soft landing, but at the same time we should remain highly vigilant to the risk that it could be something worse.
There's unrest in the Middle East
And then there's the Middle East. Will the escalating tensions lead Israel and/or the United States to launch a military strike against Iran? Will Iran then close the Strait of Hormuz, shutting down the supply of oil and crippling the global economy? It's a complete unknown. What we do know is that the United States and Europe have put heavy sanctions on Iran and its central bank, and therefore on Iran's payment system. These sanctions seem to be having quite an impact, so much so that perhaps they have reduced the need for a military strike. But there's a lot of posturing on all sides and, in my view, the stakes have never been higher.
What the charts say
Technically, the trend remains strong: The S&P 500Index is well above its 200-day moving average, and we have a pattern of higher highs and higher lows off the October bottom. The advance-decline line for the S&P has already exceeded its April 2011 highs, indicating that the index itself may soon follow. In fact, last week the Dow Jones Industrial Average already retested its April 2011 high of 12,876.
However, for the first time in months, there is some evidence of negative technical divergences for stocks. A negative technical divergence occurs when stocks make a new recovery high but certain momentum or breadth indicators don't. This is a mirror image of what we saw at the lows in early October 2011 and is something that needs to be watched, because it suggests that the market is tired here and that a correction may be in store.
Putting it all together
We have a stock market in a strong up-trend, but showing signs of technical fatigue against a backdrop of sentiment that has almost caught up to the rally. The fundamentals are strong, but perhaps they are now reflected in the price. The ECB has come to the rescue in a big game-changing way, but now the market seems to have gotten ahead of itself in anticipation of a successful second LTRO. Meanwhile, the trio of tail risks (Greece, China, and Iran) has not gone away and, in fact, there is some evidence that investors have become somewhat complacent. Perhaps it is "gloom fatigue."
So to answer the questions I posed in the beginning: How much risk is appropriate in a portfolio? Is it time to derisk, stay put, or add risk? When I put all the factors together, they tell me that things aren't bad enough to go into full hunker-down mode, but they are also not good enough to be fully invested. The risk-reward is certainly not as good as it was five months ago, when stocks bottomed amid an extreme of sentiment. Perhaps it is time to take a few chips off the table.