Shifting to Neutral on US Equities, Better Value Elsewhere in 2014

While I am not prepared to become a bear just yet, I am definitely becoming neutral on US equities through 2014. At the very least a correction is about due, even if there is no catalyst for a panic. I could become a bear later in the year, perhaps Q3-Q4, as I actually see a few risks building at the same time as the Fed will be slowing down it's easing cycle. Until there is a real catalyst for a crash though, I am only prepared to say that I think the index will finish the year +/- 5% from it's current value, roughly flat. My position is that if you want to own equities, there are many other countries trading at bargain valuations because they are out of favour. US equities are now fully priced, but countries in peripheral Europe are still trading well below long term value, and Australia's slow recovery has kept it from becoming overvalued.

Sentiment became euphoric towards the end of last year, when the Fed decided not to taper in September. Analysts, rather than shifting their estimates back 2 months to the December meeting, walked the taper back to well in to 2014, some even making the call that there would be no taper at all. This might have been sound logic at the time, but it did not eventuate - the Fed announced the taper this December. What I draw from the analyst estimates is that most overestimate Bernanke's willingness to support asset prices at any cost, and most are probably already positioned as net long as possible, given the narrative heading into December was that the Fed would keep running its extraordinary easing at 85 Billion per month and equities might go into a blow off top. Now they are still positioned for this outcome, yet the reality has changed, and the market has not reacted negatively yet.

The market did not correct after the announcement to any noticeable degree for several reasons, a few being that:

1. The taper doesn't actually begin until January.
2. The Fed strengthened forward guidance and made it clear that the taper was not the same as tightening, and that rates would stay at zero for as long as needed.
3. Tapering is still easing at 75 Billion per month, not tightening.

I am unenthusiastic about US Equities now specifically because:

1. Valuations are very high, by many measures that I care to watch - US equities are now some of the most overvalued in the world. At a CAPE-10 of 25.6 it is unlikely 5-10 year returns will be decent from here.
2. Sentiment is close to euphoria - it is unfashionable to be bearish, bears are capitulating and there is a widespread belief that the Fed will not allow asset prices to fall (I think this is misguided).
3. Extraordinary stimulus is winding down over the course of this year, the market is not positioned for this.
4. Unemployment benefits are ending for many.
5. Inflation is falling, despite efforts to raise it.
6. China faces a very difficult dislocation as it attempts to "un-repress" its economy, or re-balance away from credit fueled investment growth - this will become more obvious and problematic throughout the year.
7. The recovery, though weak, is maturing after 5 years.
8. Last year was driven mostly by multiple expansion and buybacks.

Crashes Without Rate Rises:

Something I have begun discussing in this blog, and will discuss further, is the idea that in the absence of an active cash rate policy and the move towards balance sheet monetary policy, asset purchase programs have replaced the cash rate as a signalling device. In an inflationary environment, markets normally don't crash without some sort of monetary policy tightening, normally a rising policy rate is a necessary but not sufficient condition, while an inverted yield curve has been, in recent history, a near guarantee of a recession. This precondition cannot occur currently, as the Fed will not raise short term rates, so this is taken by many to conclude that a crash is unlikely. However, when the economy's natural tendency is towards de-leveraging or deflation, as it is now, policy need not be tightened to instigate asset price falls, instead reduced stimulus is enough to spark a downturn if the economy can not yet stand on its own.

The best analog for the current market conditions is the Great Depression. The market crash of 1929 was followed by a deep and painful depression, though by 1937 (as Wikipedia puts it) the recovery appeared to be under way:

"By the spring of 1937, production, profits, and wages had regained their 1929 levels. Unemployment remained high, but it was slightly lower than the 25% rate seen in 1933. The American economy took a sharp downturn in mid-1937, lasting for 13 months through most of 1938. Industrial production declined almost 30 percent and production of durable goods fell even faster."

This was also a period characterized by falling long term rates, low inflation, global recessionary conditions and a general de-leveraging of the private sector with an opposing growth of the public sector balance sheet - which sounds a lot like the current environment. Of course the monetary system is improved and unemployment lower, conversely market valuations are slightly higher and private sector leverage is also still quite high - there are definite differences, so we shouldn't expect an exact replica to occur, but since this is the closest existing experience with the current macro environment it is worth paying attention to.

Opinions vary on the exact cause of the 1937-1938 recession, depending on your political alignment and your school of economic thought. We can't really know for sure, and I don't care to open a can of worms. What we do know is that the cash rate was not raised and the yield curve did not invert - the two normal preceding conditions of recessions were not present:

After a powerful rally off the lows of the early 30's, in 1937 the DJIA corrected 50% - the Federal Reserve was not raising rates and the yield curve was far from inverting.

The point here is to acknowledge that it is not a sufficient argument to say that, because the Fed will not tighten any time soon, this implies asset prices can not crash. These are not ordinary times, so it doesn't pay to look for ordinary analogs and it is possible for a recession/crash to occur without tightening.