An Imminent Correction in Risk Assets

In our 2014 U.S. stock market outlook (published on December 22, 2013), we asserted that U.S. stocks will only return in the single-digits in 2014, due to: 1) a tightening Fed, 2) the reluctance of the ECB to adopt quantitative easing policies, 3) higher-than-average valuations, as well as 4) increasingly high levels of investor speculation (e.g. record high levels in margin debt outstanding). We stand by our 2014 S&P 500 year-end target level of 1,900 to 2,000.

Conversations with our clients suggest one overarching investment concern/theme. Investors are concerned with the unprecedented global monetary experiments, while most of Asia is concerned about runaway Chinese credit growth and the country’s shadow banking system. The shift from a unipolar investment environment (one dominated by U.S. policy and institutions) into a multipolar one–beginning with the fall of the Berlin Wall in 1989 and accelerating with China’s entry into the WTO in 2001–means an understanding of global macro is essential to understanding the main drivers of future asset prices (hint: it is not classical indicators such as P/B, P/E ratios, etc.). Going forward, monitoring the actions of the People’s Bank of China and Chinese credit growth will be just as important as monitoring the actions of the Federal Reserve.

We believe 2014 represents a transition year as the Federal Reserve definitively halts its QE policies/asset purchases and as Chinese policymakers adopt financial reforms (e.g. allowing companies to go bankrupt to prevent future moral hazard problems) in an attempt to alleviate investors’ long-term concerns. In many ways, these recent moves–including Fed Chair Janet Yellen’s surprisingly hawkish comments at the March 18-19 FOMC meeting–are reminiscent to the events of 1994, when the Greenspan-led Fed unexpectedly began hiking the Fed Funds rate in February 1994. The Fed Funds rate rose from 3.0% to 5.5% by the end of the year, while the two-year Treasury yield surged from 4.0% to more than 7.5%. The S&P 500 experienced significant volatility and finished down the year by 1.5%.

We do not believe the Fed will hike the Fed Funds rate anytime soon; however, we anticipate the Fed to halt its QE/asset purchase policies by the end of this year; and to begin hiking rates in the 1st half of 2015. That is, global liquidity will get tighter as the year progresses–further compounded by overbearing U.S. financial regulations, a hike in the Japanese sales tax this week from 5% to 8%, and the ECB’s reluctance to adopt a similar QE policy. The action in the S&P 500 in the 1st quarter of this year has so far proved out our thesis. The S&P 500 ended 2013 at 1,848.36 and as of last Friday, sits at just 1,857.62 for a meager 0.5% gain. We reiterate our year-end target of 1,900 to 2,000. In the meantime, we believe the S&P 500 is heading into a significant correction, i.e. 10-15% correction over the next 3-6 months–for the following 3 reasons.

1) Hot Money Action is Getting More Risk-Averse

Since the global financial crisis ended in early 2009, EM fund flows from DM countries have been highly positive. Fund flows to EM countries turned negative during the summer of 2013. Many EM countries never implemented much-needed reforms during the last boom (Russia leadership just proved it is still stuck in the 19th century), nor made much-needed infrastructure and educational investments (with the major exception of China). Investors have forgotten that EM growth (actual and potential) rates no longer justify such investment fund flows–and have continued to dial back risk-taking in general. Most recently–the stock prices of two of the hottest industries, i.e. Big Data and Biotech–have taken a significant hit in recent trading. We believe momentum investors are now leaving the stock market; and that there is a good chance this will turn into a market rout (i.e. S&P decline of 10-15%) over the next 3-6 months.

2) The Federal Reserve’s Monetary Policy Tightening

Once the Federal Reserve wrapped up its “QE2” policy of purchasing $600 billion in Treasuries at the end of June 2011, the S&P 500 subsequently corrected by 14% over the next three months. The S&P 500 had already declined by 3% during May/June 2011, as the Fed did not provide a clear indication of further easing (i.e. QE3) until later in 2012. Prior to the end of QE2, the Fed purchased an average of $17.5 billion of Treasuries on a weekly basis. At the peak of QE3 (i.e. before the recent tapering), the Fed was purchasing an average of $20.0 billion of Treasuries and agency-backed mortgage securities on a weekly basis. The current tapering process is already having an effect on global liquidity, as foreign reserves held by global central banks have been declining over the last couple of months. Based on the current tapering schedule, the Fed will halt its QE policies at the October 28-29, 2014 FOMC meeting. The Fed’s balance sheet of $4 trillion of securities will take a decade to unwind (if ever). Unless the ECB chooses to adopt similar QE policies, we believe global central bank tightening (EM central banks are projected to tighten further over the next six months) will act as a significant headwind to equities and other risk assets for the rest of 2014.

Feds Balance Sheet

 3) A Record High in U.S. Margin Debt Outstanding

Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators, as well as major peaks and troughs in the U.S. stock market. We first discussed this indicator in our January 29, 2014 commentary (“Record Rise in Margin Debt Outstanding = Single-Digit U.S. Stock Returns in 2014“). We asserted that the record rise in margin debt outstanding (a 12-month rise not seen since July 2007–during the last major peak in stock prices) is indicative of significant speculation in U.S. equities. Since our January 29 commentary, U.S. margin debt outstanding has risen another $23.6 billion to a record high $502 billion. Meanwhile, the 6-month rise in margin debt outstanding hit $88 billion–again, a high not seen since July 2007 (when it hit $105 billion). More important, it is clear to us–based on the action in Big Data and biotech stocks over the last couple of weeks–that the willingness to speculate is declining. All of these indicators suggest to us that the S&P 500 will experience a major 10-15% correction over the next 3-6 months. We also assert that Emerging Market stocks will experience a significant decline, along with gold prices. We expect gold prices to bottom at the $1,000 to $1,200 an ounce level over the next 3-6 months. We will look for a buying opportunity in both gold and North American gold-mining stocks sometime in the next two quarters.
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