DAY HAGAN RESEARCH UPDATE
A look at the perspectives of some very smart people who have completely opposite views on where the markets may head.
Donald L. Hagan, CFA
August 16, 2016
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On August 11, Ned Davis Research (NDR) released a report titled, “More Secular Potential… 12 Signs of Continuity.” (As you may know, I started my financial research career with NDR back in 1988 and have the utmost respect for their depth of knowledge and ability to bring together myriad factors from around the world to arrive at reasonable conclusions.) The report supported their view that the current secular bull market that started on March 9, 2009, is “far from over.” This coincides with our longer-term outlook as well.
In essence, and I am paraphrasing, they see continued upside longer term. While there are likely to be bumps along the way, the long-term trend is currently rated positive.
For example, NDR believes that economic growth will improve and support an upcoming earnings recovery. Alongside the growth, investor confidence and investors’ risk appetites will pick up and equity prices will likely trend higher as investors once again accumulate equities.
NDR’s view is that we are current experiencing a cyclical bull market within a secular bull market, which has typically produced outsized returns. By their reckoning, cyclical bulls of this nature have typically lasted 753 days and gained 107 percent. They see the start of the latest cyclical bull as 8/9/2016. Therefore, this would clearly indicate room to the upside.
They also analyzed all secular bull markets since 1941, and found that the S&P 500 had typically gained at an 18.5 percent average annual rate. However, they also found that during secular bull markets, there were some years that were up less than 5 percent. Historically, for the year following a “weaker” year, the S&P 500 was up 26.8% on average. This is interesting, because we know that 2015 was up less than 5 percent..
NDR views global equity markets as undervalued relative to bonds. They point to the ACWI (global stock index) median earnings yield of 5.05 percent (based on 35 components) versus the median 10-year Government bond yield based on 35 MSCI ACWI Components of 1.17 percent. The spread between the earnings yield and what can be earned on bonds favors stocks. They cite “cheap stocks” relative to “expensive bonds” as “one of the most compelling underpinnings to our argument that a new era for allocation has gotten underway.”
Further, NDR asserts that slight upticks in interest rates or inflation, as well as some monetary policy normalization, could be withstood by equity markets. They also view commodities and currencies as mired in trading ranges that would likely preclude shocks for the time being.
For signs that the cyclical bull, or more importantly, the secular bull, were to be in peril, they cite “surging oil prices, inflationary pressures, and/or escalating bond yields.” In their view, none of those factors are currently in place. (Again, to be clear, I am paraphrasing the excellent work of Tim Hayes, Steve Sellers and Anoop Nath of NDR to define the basics of the case for higher equity prices.)
Stan Druckenmiller was the founder of Duquesne Capital and was working with George Soros when he made his famous bet on Pound Sterling in 1992, ultimately forcing the withdrawal of the pound sterling from the European Exchange Rate Mechanism. My view is that he has a good history of calling major macro trends.
Recently, Mr. Druckenmiller presented to a conference of hedge fund managers his bearish views of the U.S. equity markets. He cited:
- “The Federal Reserve’s monetary policy over the last eight years has led to unproductive and reckless corporate behavior.” He points out that operating cash flows for U.S. non-financials peaked in 2010 and are currently negative while debt has exploded over 25 percent over the past year (through Q1 2016). Never in the post-World War II period has this happened. The current 5-year divergence is unprecedented in financial history.
- He then goes on to illustrate that “the corporate debt that has been taken on today has been used mostly for financial engineering as opposed to productive investments.” During 2015, buybacks and M&A activities totaled $2 trillion. That compares to all Research & Development and office equipment spending of just $1.8 trillion.
- From a valuation perspective, he says, “If we have borrowed more from our future than any time in history and markets value the future, we should be selling at a discount, not a premium to historic valuations. It is hard to avoid the comparison with 1982 when the market sold for 7-times depressed earnings with dozens of rate cuts and productivity rising going forward vs. 18-times inflated earnings, productivity declining and no further ammo on interest rates.”
- Lastly, “I have argued that the myopic policymakers have no end game,” Druckenmiller said. "They stumble from one short-term fiscal or monetary stimulus to the next despite overwhelming evidence that they only produce a sugar high and grow unproductive debt that impedes long-term growth. Moreover, the continued decline of global growth despite unprecedented stimulus the past decade suggest we have borrowed so much from our future and for so long that the chickens are now coming home to roost."
While this is clearly an abbreviated view of both NDR and Mr. Druckenmiller’s views, our goal was to highlight that there are very smart and highly experienced people who have diametrically opposed views regarding the current state of the market as well as its future potential. And, interestingly enough, both cases are viable.
We rely on our quantifiable, disciplined process that utilizes a weight-of-the-evidence approach. Our goal is to stay in tune with major trends, knowing that we don’t have to bet the farm on bullish or bearish prognostications, and that we can risk-manage our portfolios with the appropriate balance of cash and equity holdings that are supported by model strength.
At this point, our models’ message is that this isn’t the time to be overly bearish (negative), nor is it the time to be overly aggressive. A more neutral/mildly bullish stance is currently warranted. We will be looking for our models and the weight of the evidence to turn more positive before committing additional capital to equities.
If you have any questions or comments, please feel free to call anytime.
Have a wonderful week,
Donald L. Hagan, CFA
Day Hagan Asset Management
Day Hagan Investment Research
— Written 08-16-2016
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