Raul Elizalde - February 20, 2012
After a harrowing ride that took the S&P 500 down 20% from the previous peak to the trough of last October, stocks roared back virtually back to where they started. Additionally, volatility has plummeted – usually a sign that markets have regained their footing.
This bull stock market phase has been accompanied by a significant compression of European sovereign bond spreads. After a few months when the very future of the eurozone was in question, policymakers seem to have convinced markets that they can protect the banking system and contain the Greek mess.
SPAIN 2-YR BOND YIELD
ITALY 2-YR BOND YIELD
This led to a sharp fall in the yields of Italian, Spanish and Portuguese government bonds (see graphs). While 2-year Greek bonds, at a yield of 200% priced somewhere between a restructuring and a messy default, other peripheral countries are now trading at levels that suggest that the Greek chaos will not spread.
The deep concerns about the US economy have receded as well, especially on the employment front. Weekly unemployment claims are practically at a 4-year low and well below the 400,000 mark. Broader measures that account for discouraged workers and those working part-time have improved as well.
Housing starts, long the bleakest spot in the economy, are now hovering around the highest levels since the end of 2008, along with industrial production and railroad train traffic. Retail sales are at record high.
But although qualitative, “fundamental” analysis of the current environment is strongly encouraging, quantitative, “technical” market signs are not as convincing.
Although the price action of the last few months would suggest that US stocks could have a banner year (see “2011 Part II – Can 2012 be different?” 1/5/12), investors, emotionally weak after three or four years of violent swings, aren’t too sure.
According to the Investment Company Institute, investors redeemed shares of equity mutual funds every month from May 2011 through January 2012 to the tune of $175 billion. The first week of February 2012 registered another $1.7 billion in outflows. And although Exchange-Traded Funds (ETFs) that invest in equities fared much better, they still had fewer assets at the end of December 2011 than at the end of the previous May. While it is possible that investors simply made a switch from mutual funds to individual stocks, the data strongly suggests that the vast majority of those flows went into bond funds instead.
This is reinforced by the decrease in trading volume for S&P500 stocks. Volume has gone down for the past few months even though volatility is markedly lower – negating, incidentally, the widespread belief that light trading volumes make stock prices more volatile.
More worryingly, correlation among stocks has remained exceedingly high. A measure of the average correlation of stocks against the S&P500 peaked in December and has remained elevated since. This is particularly inconvenient to stock-pickers, who try to beat indices by identifying the “best” stocks: when all stocks move in sync, the rewards of stock-picking are indeed very slim.
Correlation among different asset classes is also very high. Large- and small-cap stocks are tightly correlated, as well as US and international stocks.
This environment forces investment managers to increase their focus on timing and less on identifying value. Hence the “Risk-on/Risk-off” condition that reigned over the last couple of years, as managers either pour money into risky assets or shun them, largely indiscriminately, in accordance to whatever the prevailing mood may be.
The reason to be concerned, therefore, is that the “technicals” and the “fundamentals” are out of step. While the “fundamental” story is supportive of higher prices, and indeed prices have followed the increasingly positive mood, the market’s internal dynamics tells us that conviction is simply not there. Could it be that the market “knows” something we don’t know? Is this a “bull trap”?
There is an alternative interpretation of the “technicals.” Precisely because investors have been slow to commit to the market, there is a potentially large pool of buyers waiting on the sidelines. This would be a strong engine for future price appreciation and an excellent reason to enter now. If everyone was already committed, it would be too late to jump on board.
A sustainable rally needs not only a solid fundamental background, but also continuous demand from buyers who have not yet entered the market. With an increasingly positive background, higher demand for stocks looks possible in the months to come.
Raul Elizalde | raul@pathfinancial.net
©2011 Path Financial LLC
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