The S&P 500 (SPX) is on pace to triple its March 2009 low of 676.53 in 2014, leaving many wondering what is driving such an unprecedented bull market. Indeed, a widely respected figure at a major financial news network said to me earlier this month, “Even in the media, we’re left scratching our heads by a lot of what we’re witnessing right now.”
On Thursday the SPX touched an intraday peak of 1991.39 to close at yet another new all-time high of 1987.98. The 10-year Treasury yield had closed the previous session at 2.464% – near its lowest closing level in 13 months reached in May of 2013.
Perhaps the increasing number of marijuana-related stock listings is beginning to impact the market’s short-term memory. One week ago Thursday, Russian separatists shot down Malaysian Air Flight MH17 over the Ukraine. That same day Israeli troops invaded the Gaza Strip – their first ground action in the region since 2009.
Strange times, indeed.
So what are the drivers behind this unprecedented bull market, and how soon might we expect them to run out of gas?
Lack Of Investment Alternatives
Historically equity bull markets are associated with low bond prices and increasing yields, as a generally strong economic outlook pushes investors into stocks and out of treasuries.
Since having assumed the role of lender of last resort in 2008, the Fed’s balance sheet has quadrupled from $850 billion to nearly $4 trillion as it seeks to end its third and final round of quantitative easing.
In June the FOMC announced the fifth consecutive $10 billion cut in its bond buyback program, reducing monthly asset purchases to $35 billion. In the following press conference, Fed Chair Janet Yellen cited elevated’ unemployment and ‘underutilization in the labor market’ as reasons we shouldn’t expect an interest rate hike anytime soon.
Many believe the market has already priced-in the cessation of QE3 – after all the S&P 500 is up almost 10% since December and moves higher with each taper announcement. The buyback program is on pace to end in October, and it’s likely the markets won’t fully react until Spring 2015. When this reaction does come, a correction of 15%-20% is not unlikely given the magnitude of the bull market we are currently in.
Record Corporate Earnings
Two thirds of companies in the S&P 500 have beat on revenue in 2014. Even banks, expected to underperform under the burden of high litigation costs and a tight lending environment, were able to beat analyst expectations.
US corporations had a record year in 2013 with $1.68 trillion in after-tax profits, and 2014 is estimated to be more of the same. The fact that the rising valuations we see each day are backed by hard numbers offers solace to those concerned we’re in a stock bubble, but shouldn’t offer too much comfort.
The low-cost lending environment has led many companies to restructure debt, but while lower capital costs improve balance sheets in the near-term, this doesn’t offer a long-term solution. Again, high interest rates are historically good for equities, but the opposite has held true in the current economic environment.
Global Macroeconomic Outlook
United States
Despite first quarter GDP contraction, broader economic data such as labor statistics and manufacturing surveys, suggest a steady acceleration of growth. According to Goldman Sachs economist Jan Hatzius, the latter half of 2014 should see even more capital spending. New home construction impacted by mortgage rates is expected to accelerate, as these numbers have been weak in the previous quarters. We continue to see indicators of pent up housing demand, and this could slowly reverse in late 2014 through 2015. Housing is seen as poising the largest threat to the US economic recovery, with student loan debt and a tight mortgage lending environment being highly detrimental to first time home buyers.
Europe
Germany is the strongest economy in the European Union, and continues to outperform expectations. On the other hand, laggards such as Italy and France continue to underperform and miss expectations. European Central Bank President Mario Draghi has reiterated the bank’s willingness to take whatever measures necessary to preserve single currency, and this has worked to soothe the markets. Economic restructuring and public finance reform is necessary to ensure the viability of balance sheets in the near-term, however, and inaction in this regard poises a major threat to the health of the European economy.
Latin America
Mexico is clearly the bright spot in the region, a viewpoint driven by credible economic policy and leadership coupled with a lack of macroeconomic imbalances. In the near-term the Mexican economy will be a beneficiary of growth seen in the United States (putting it at risk from any headwinds facing the US economy). Legislation passed in late 2013 ended a 75-year government monopoly on the petroleum industry, opening it to domestic and foreign private investment. Similar measures were taken to end monopolies in the telecom industry, and tax reforms set to increases revenues and encourage investment should positively impact GDP in the medium term. Major risk factors are mostly legislative, should politicians fail to act as necessary to see the reforms through.
The other major regional economy, Brazil, is trapped in a pattern of low growth and high inflation. An adjustment in monetary policy, along with reforms similar to Mexico, are seen as necessary to bolster growth across the medium term.
China
The IMF expects China’s economy to post 7.4% growth in 2014 (versus a goal of 7.5%), with further declining to 7.1% in 2015. Manufacturing and retail sales numbers have been consistently weaker than expected throughout 2014, and more accommodative monetary policy is seen as being necessary to jumpstart the economy. Headlines surrounding the Chinese government’s crackdown on corruption have been pervasive throughout 2014, with such measures threatening growth in the near-term. Finally, a sharp drop in housing demand (including a 22% drop in new construction) round out the factors contributing to weak economic growth in the region.
Low Volatility
A few months ago a veteran CNBC reporter, apparently dissatisfied with the continued uptrend in SPX and the corresponding low volatility environment, theorized the VIX was ‘broken’ and no longer ‘adequately reflected fear’ in the marketplace.
While the mathematics behind index calculation may be a tempting scapegoat for the record market highs we are experiencing, a more rigorous analysis of volatility is probably in order.
One week ago Thursday, following MH17 being shot down over the Ukraine and Israel’s ground action in Gaza, the VIX spiked over 32% to close at 14.56. While this represents the biggest one day volatility move in 15 months, unto itself this is not exceptional. More interesting is the fact the S&P 500 dropped by only 1.2% – the smallest percentage drop on a day the VIX has risen over 30% ever.
Following these events volatility observers can concur the VIX accurately reflects fear, at least so much as this emotion is measured by implied volatility in the SPX options market. Low VIX levels and continued all time highs in the S&P 500 instead are indicative of the complacency felt by market participants.
Rather than the VIX inaccurately reflecting fear, what we are seeing is fear in the market failing to accurately reflect the reality of the current geopolitical environment.
Remember, cheap volatility offers asset managers inexpensive means of hedging a long equity portfolio. If S&P 500 returns weren’t already tempting enough, low volatility further encourages investment in equity markets.
In Closing
Bull markets continue to go higher – until they don’t. While such a statement of the obvious is clearly unnecessary, it serves to illustrate the difficulty of predicting the timing of a market correction. An unapologetic bull, I am still unable to find justification for being anything other than net long the market. As we continue to carve out new highs, it is increasingly important to be stock specific in any equity or option portfolio. Great care should also be taken to properly hedge one’s portfolio, be it through VIX options or puts on the benchmark indices. I do not expect any major economic disruption to occur in 2014, but investors and traders alike would be well advised to keep an even more watchful eye on macroeconomic data towards year end as they consider unwinding long portfolios.
Related Reading
How To Read Order Flow For Unusual Options Action by Andrew Keene
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