Wednesday, January 1, 2014

The Higher They Go

The rubber band is stretching.  The valuations are reaching nosebleed levels.  The higher they go, the harder the fall.  The tailwind of lower interest rates has been exhausted.  Increasing budget deficits to fuel economic growth is not politically possible anymore.  Where are the corporate profits going to come from?  We are already seeing S&P 500 profit growth slow to low single digits, with Q4 estimates going down.  There is no catalyst.  Asset price rises have minimal effects on consumer spending behavior, otherwise, you would see retail sales up huge with the surging S&P.

For the developed world, the demographic dividend of a growing population of middle aged, economically active consumers aged 25 to 50 has flatlined.  Look at the table below for the U.S. population, rising from 2000 to 2010, overall, but the 25 to 44 year population growth is negative.  Those over 50 are growing rapidly, but they spend much less money than their younger peers.  The age 25 to 50 population was growing rapidly for most of the past half century, providing an upward drift to the global economy.

Sex & Age Group2000 Population2000 Percent2010 Population2010 Percent2000-10 Change2000-10 %Change
 25 to 44 years85,040,25130.282,134,55426.6-2,905,697-3.4
  45 to 64 years61,952,63622.081,489,44526.419,536,80931.5

The situation is even more dire in Europe, and is in a crisis state in Japan.  That is why Abenomics will fail, because the domestic demand is not there, due to an aging population, and exports do not increase enough to make up for it even with a weak yen.  The Nikkei is in a much more precarious state than the S&P 500.  It has the most potential for a nasty unwinding as there is the double whammy of the long USDJPY trade unwind as the global economy weakens.  Remember, USDJPY was at 120 back in the 2000s because the carry was enormous when Fed funds rates were at 5% and Japanese short term rates were at 0.25%.  There is no carry to holding USDJPY long, it is just hope that JPY weakens more than USD.

The emerging markets are not the answer, they already offer up enough exports for the developed world's now flatlining needs.  So the emerging markets only answer is to grow domestically, to increase consumption, but that happens on the back of better wages, but you only get better real wages if you add more value, otherwise it is just inflation.  Or if you get better wages and don't add value, that just kills corporate profitability.  And the key for the emerging markets, China, is no longer able to grow without unsustainable rates of credit growth, something that new Chinese leaders are finally realizing.

According to Soros's theory of reflexivity, market participants have a bias that affects market prices, and vice versa.  The bias gets reinforced as the trend continues, until the bias is questioned, and then proven false, as the weight of the fundamentals comes to bear on the marketplace.  Right now, the bias is the omnipotence of central banks for providing high returns for equities.   This bias is in an advanced stage, with QE in the US in its 5th year, ECB LTROs used, and Japan trying to massively devalue their way to prosperity.  The fundamentals for equities are dreary, but this has been overshadowed by the current market bias and strong price action.  But with the valuation extremes and overall bullish positioning of the investor community, I see very limited upside, and lots of downside.

Central banks wield the most power in the bond market, not in the stock market.  With limited upside in bonds, traders are chasing stocks.  But I view it in a different way.  Without strong global economic fundamentals, I see limited downside in bonds because tapering will stop, and then eventually lead to increases in asset purchases at the first sign of weakness.

The perception has overwhelmed reality.  2014 will be the year when investors question their bias of buying equities because of central bank support.  This should lead to choppy markets, with risk for a big drop in the 2nd half of the year.

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