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Is the Market Poised for a Major Shift in 2014?

'Greed' may be a deciding factor for investors

   

So, I know what you’re thinking. After a 30% gain in 2013, is the market overheated and ready for a rip lower in the next month or year?

According to analysts at TIS Group in Minneapolis, a boutique investment research and management group, one way to answer the question is  to look at the returns of the current rally in an historical context. The chart below (created by Chart of the Day late last year) does that by comparing the current rally — after a major bear market — to other rallies that occurred after major declines.

Stock Market Rallies1 Is the Market Poised for a Major Shift in 2014?

The answer seems to be that the current advance, which started in March 2009, has now reached only a medium magnitude relative to other recoveries and thus could potentially have a lot of room overhead for further gains.

Of course, it has taken four intensifying phases of quantitative easing by the Federal Reserve, as well as an earnings recovery and billions of dollars of corporate buybacks, to get us this far. The real question is: What could power the next leg higher?

And the answer is one word: greed. It’s a key element of every market, and so far it has not made much of an appearance yet. The American Association of Individual Investors members who consider themselves bullish are not even at the 50% level, while the number of AAII members who consider themselves bearish is likewise subdued. There are a lot of ways to measure sentiment, but almost every measure suggests that there is in no way a bubble-like mentality yet.

It’s coming, though. There is no way that investors still in bonds will stand by getting nothing while their peers in stocks are royally rewarded. The number of people invested in equity funds is starting to grow in sync with the number of bond funds that are about to turn in negative returns for the year. The great bond-to-equity asset allocation switch has not yet occurred, but there are signs that it might actually get started in the first half of next year as allocations are reviewed and changed at dining-room tables as well as in pension board rooms.

After all, no returns on cash are one thing, but once people really recognize that they are getting negative returns on their bond funds, well … as TIS Group’s veteran analysts argue in their Market Intelligence Report, “you are going to see a whole different dynamic.” Their guess, and mine, is that there will be a call among both mom-and-pop investors as well as pension-fund consultants to favor equities over bonds to a greater degree.

While this is true in the United States, it is going to be even more true in Europe and Japan, where investors are even more overweight in bonds at present. Many pension funds in those countries own less than 10% or even 5% equities. Consultants are going to note that holding bonds is virtually indefensible in an era of quantitative easing, as returns are below the level of inflation. That’s a “negative real yield,” which is indefensible at almost any time — but even more so when stocks are rising and their valuations are not changing.

While you may have heard that hedge funds underperformed in 2013, the same can be said for sovereign-wealth funds, many of which are overweight in emerging-market debt and woefully underweight in equities. Their boards are going to make sure that they figure out how to catch up. This was already stated by Oeystein Olsen, central bank governor in Norway, who also noted that the oil-rich country plans to more actively manage 25% of its equity portfolio to boost returns.

This new view of equities will come about at a time when the U.S. economy is still vulnerable and even anemic, with GDP growth in the area of 2%-2.5%.

While the Fed has made its initial moves to taper, there will almost certainly be no tightening, or raising of rates. Yes, politics do come into play at the Fed, especially from a new chairman who owes her job and career highlights to the outgoing chair — who has made a recovery the centerpiece of his legacy — and to a president who is bound and determined to help his party retain the Senate if not actually regain the House.

The bottom line is that I suspect stocks will keep advancing and have a shot at recording another 20%-plus year in 2014 as families and pension-fund managers alike allocate more of their funds to equities and eschew bonds. TIS Group analysts sensibly recommend watching the first week of January, and then the rest of January, for clues to sentiment for the rest of 2014. If there is no immediate start to a reversal of the improving sentiment in the first month of the new year, odds will greatly improve that 2014 will be another positive experience for active investors, if not an actual barn-burner like 2013.

Then you can really get to see what a bubble looks like. And you will hear me say more than a few times that the first rule of bubbles is that it is imperative for traders to participate in them while they are inflating. It’s only the aftermath that you need to worry about, and they typically reverse with a slow leakage, not a crash — so there is usually a decent amount of warning if you know where to look.

Jon Markman may hold some of the aforementioned securities in his Trader’s Advantage or Counterpoint Options portfolios.

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