“In the short run, the market is a voting machine, but in the long run it is a weighing machine.” —Benjamin Graham
As Ben Graham so eloquently stated in the quote above, in the short run the stock market is very much a voting machine in which psychology and sentiment are the key drivers of market direction. Critical to this psychology is control over the narrative or story behind the market. Throughout this year, the US equity bulls never lost this control and as a result we have seen one of the smoothest advances in history. For every bearish punch the bulls have had an even stronger counterpunch. The following narratives may sound familiar:
On the critical subject of interest rates, both higher and lower rates have been portrayed as bullish for equities. In March and April when rates declined, this was viewed as bullish for equities because stocks were “cheap” on a relative basis as compared to bonds. When rates began to move sharply higher in May, there was a brief hiccup in equity prices but the argument quickly shifted; higher rates became bullish for equities as it was an indication that the economy was improving.
On the subject of commodity prices, US equity bulls, especially in small-cap domestic indices like the Russell 2000 (IWM), have been similarly successful in controlling the narrative. When commodity prices declined from February through June, this was viewed as bullish for equities as it was a sign that inflation would not impede quantitative easing and would put more money in the pockets of US consumers.
When commodity prices and Crude in particular rose in July and August this was also bullish as it was a sign of an improving global growth. In recent weeks, as commodity prices have been moving down sharply once again, the narrative has shifted back to low inflation and more money for the US consumer.
On the subject of economic data, all news has been equally favorable. Worse-than-expected data has been welcomed as a bullish signal due to the expectation that the Federal Reserve would maintain its policy of record easing. Better-than-expected data has also been viewed favorably as a sign of improving growth. The past two employment reports illustrate this concept as stocks rallied with a worse-than-expected report in October and a better-than-expected report in November.
On the subject of quantitative easing, we have seen both sides argued as well. Signals of more quantitative easing from the fed have been viewed as bullish as investors have come to associate QE with continued equity gains. In May of this year, when tapering of QE was mentioned, the equity markets initially suffered a pullback.
However, in June the markets quickly reversed and rallied right up until the September Fed meeting in which most were expecting a taper. The narrative had shifted by this point to a bullish interpretation of tapering because it was a sign that the economy was finally strong enough to stand on its own. The Fed, of course, did not end up announcing a taper in September which was also viewed very favorably. The narrative had shifted once more.
These narratives, of course, are not held up on their own. Critical to their success has been the positive feedback loop in US equity prices. The 2013 positive feedback loop has been stronger than almost any other year, as all minor dips have been bought. With each successful buying of the dip and subsequent new high came a reinforcement of the above narratives. This in turn encouraged more buying and moved more investors on board with the bullish narrative.
But alas, no bullish narrative lasts forever. At some point, all of these narratives will breakdown as it will become too difficult to put a positive spin on negative news. For example, at a certain level higher interest rates will inevitably be viewed as inflationary which in turn will jeopardize QE which in turn will be viewed as bearish for US equities.
The question, of course, is when this breakdown will occur. Typically, as the bullish narrative is largely a function of the positive feedback loop, investors only lose faith in the narrative when prices move lower. In recent weeks we have seen increasing signs of weakness that typically precede corrections in stocks.
However, given the strong momentum in US equities and favorable seasonality until year end, any large correction may have been pushed into early 2014. Until then, enjoy the narrative, as all news is likely to be good news.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.