What’s in my crystal ball for 2014 and beyond? It may not be as clear as you’d like. I see three possible scenarios for the markets, the economy, and the Fed.
- A new secular bull for stocks: Rates rise as the Fed exits QE (quantitative easing), but the markets don’t react because real GDP is growing at more than 3% and payrolls are increasing. This sustained higher growth will drive stocks upward.
- Another bear market for stocks: A deflationary relapse, causing another bear market for stocks (and much lower bond yields), which puts the finishing touches on the secular bear market that has been in place since 2000.
- More of the same: A continuation of the new normal, with slow growth, low interest rates, ongoing QE, and more asset price inflation prevents the Fed from tapering dramatically.
Let’s dig a bit deeper into each scenario—and my odds for each.
New secular bull market—my odds: 30%
In my view, there are four ingredients required for a secular bull market in stocks:
1. A technical break-out
Technically, the S&P 500 has now made new all-time highs on a nominal price basis as well as a total return basis and the major trend-lines covering the 2000 and 2007 peaks have been broken. The one thing that has been missing, however, is that all previous secular bear markets had three distinct cyclical declines, whereas the 2000–2013 period only had two (2000–2002 and 2007–2009). This is what has kept me from being willing to declare the old regime to be over.
2. Escape velocity amid a synchronized global expansion
Fundamentally, things are less clear. In my opinion, for a new secular bull market to become a reality, we will need to see escape velocity and organic growth; so far there is little evidence of either. While a few indicators have picked up steam in recent weeks—GDP, Institute for Supply Management (ISM), payrolls, retail sales—it is way too early to tell whether this is the start of a trend. And while third-quarter GDP growth is up strongly, most of that was due to a buildup of inventories. A look at the plunging fourth-quarter growth estimate shows that Wall Street is looking for those gains to be reversed.
On the brighter side, a more synchronized global recovery would definitely be a plus, and that is what we are getting now. The latest round of the Purchasing Managers Index (PMI) shows that about three-quarters of all countries are in expansion mode (i.e., >50 PMI).
3. Rising monetary velocity
Another ingredient that I think will be needed is higher inflation and monetary velocity. The 2000s were plagued by disinflation (the Fed’s worst nightmare), and we will need to see an end to this in order to sustain a new secular bull. In other words, money needs to start moving faster through the economy, building up inflationary expectations and getting companies and people to spend more. So far, there is scant evidence of this.
4. A “great rotation” into stocks.
Last but not least, in my opinion the final ingredient for a secular bull market is a great rotation out of bonds and into stocks. Bond funds and ETFs have seen their assets mushroom by hundreds of billions (USD) since 2007, while equity funds were all but ignored until just this year, when flows finally picked up. If investors start to rotate even some of those hundreds of billions into equities, that would turn a stiff headwind into a strong tailwind. While equity flows have been strong this year, it’s too soon to say whether this is the beginning of the long-awaited great rotation. Of course, what happens to bond yields on the other side of this great rotation and how rising yields will affect the economy, and therefore the stock market, remains to be seen.
All in all, the prospect for escape velocity and a secular bull market is intriguing, especially with the recent pickup in the economy, but the evidence is inconclusive at this time. I give it 30% odds.
Another bear market—my odds: 20%
While it seems far-fetched to think that the economy could just roll over here and give us another whiff of a deflationary contraction, it’s not something that can be ruled out.
What would cause a relapse? Well, it’s hard to see anything starting in the U.S. Growth has been consistently midcycle for some time now, and even with the taper now in effect, the Fed will keep printing money as long as needed, erring on the side of doing too much QE and risking price inflation and potential financial fragility over doing too little and risking a downturn.
There are some hints of deflation. TIPS break-evens plummeted last spring, copper remains in a bear market, and core personal consumption expenditures are barely at 1% (well below the Fed’s 2% threshold). Also, housing news has become more negative lately (especially in the high-flying renovate-to-rent markets), and refinancing activity has fallen. Earnings growth has fallen into the mid-single-digit range, while the S&P 500 is up five times as much.
Nevertheless, it is difficult to imagine the U.S. economy just rolling over here. Even though the economic expansion is now five years old, since WWII the average expansion cycle has lasted closer to 10 years instead of the usual four or five. That may be especially the case this time around given how tepid the recovery has been and how easy monetary policy remains.
So, if a relapse is going to happen, it may come from another part of the world. Perhaps Europe? After all, growth remains weak, structural imbalances remain, and the European Central Bank (ECB) has seen its balance sheet shrink as banks pay off their LTROs (long-term refinancing operations). This is a form of passive tightening, and money supply growth has turned down as a result. But, a sustained relapse in Europe is hard to see here with the ECB clearly committed to doing whatever it takes to keep everybody solvent and liquid.
What about China? Can a bursting China bubble become a systemic event for global markets, or would it be an insular event that affects only China and the emerging markets? Hard to tell. More and more Chinese borrowing is coming from overseas sources these days, so perhaps a credit crisis in China does have the potential to become a more systemic event than it could have been in the past. We’ll see.
All in all, an imminent deflationary relapse seems like a distant possibility at this time. I give it 20% odds.
More of the same—my odds: 50%
The new normal is a tepid but positive growth trajectory, very low inflation, interest rates zero bound, and QE continuing in some form. So, the question is: If the economy does not relapse or reach escape velocity, and things stay in the 2% real growth range and the 1% inflation range, and the Fed’s balance sheet balloons up to $5 trillion or higher, at what point does a bull market turn into a bubble, and when and how does it all unravel?
This is an impossible question to answer, and it would be foolish to try to pick a top on this basis. The fact is that the stock market has been following the Fed’s balance sheet higher in lockstep since 2009, so why bet against it?
That means more asset price inflation and more multiple expansion going into 2014 until the new normal either finally turns into escape velocity and the Fed can finally get out, or too much becomes too much and we get financial instability. Which one will it be? Nobody knows. I place the odds of this third scenario at 50%.
All in all, there is much for investors to keep an eye on—which should make for an interesting year.