When I line up all the reasons equities could continue to advance in 2014—against the reasons we could see the first meaningful 10% correction since 2012—I come out about even. In other words, I’m cyclically—and perhaps even secularly—bullish, but tactically a little cautious.
My bull case
There are many reasons to be bullish. Cyclically, the United States, Japan, and Europe—especially Germany—are all in a midcycle expansion, and the global economy seems more synchronized than it has been in years. The probability of the U.S. economy finally reaching so-called escape velocity, or sustained higher GDP growth, seems higher now than it has been for a while, and this could finally give the Fed the opportunity to eventually exit quantitative easing (QE).
It is also possibile that the secular trend for equities is now bullish instead of bearish. This means that the market could be positioned to return 18.5% (the historical average annual return for secular bull markets) instead of 1% (the average for secular bear markets). The 21.5% annualized return for the S&P 500® Index since March 2009 is more consistent with the bullish scenario.
Reasons for caution
On the other hand, we don’t know if escape velocity is happening yet, especially after the most recent payroll and durable goods reports. And even if it is, last year’s 32% gain for the S&P 500, despite a modest 5% growth in earnings per share, suggests that escape velocity is already priced in to some extent. On top of that, the Fed is tapering QE.
The result of last year’s disconnect between price and earnings is a climbing price-earnings (P/E) multiple: 18.5X on a trailing reported basis, 16.9X on a trailing operating basis, and 15.8X on a forward basis. That’s a 20% multiple expansion in one year and a 70% expansion since the low in 2009. Not only has the market discounted a lot of good economic news through a rising multiple, but sentiment surveys show bullishness.
Trouble in China and emerging markets
Now comes the troubling news out of the emerging markets (EM). On the surface, there seem to be two separate issues in EM. One is China and what is happening to its shadow lending system, and the other is the severe weakness in many EM currencies and therefore their markets in general. (Formerly high-flying countries like Indonesia and Turkey come to mind.) However, the two issues are related.
Let’s take China first. The inevitable is now starting to happen: Some of the speculative loans (called wealth management products) emanating from China’s underregulated shadow banks in recent years are now going sour. Why does this matter? I think there is an assumption among investors that the Chinese government has the wherewithal and willingness to bail out its banks and any bad loans, making a financial crisis in China at worst short lived and not a systemic event for developed market equities. This assumption may well be right, but the bad loans aren’t emanating from China’s traditional banks (which are controlled by the central government), but from shadow banks. Furthermore, these loans are less regulated, so they could represent a moral hazard for the government (i.e., if the government bails out one bad loan, will it have to bail out all of them?).
This is why the PBoC (People’s Bank of China) has been playing hardball with these lenders over the past year or so, in terms of how much liquidity it provides to the funding market (Shanhai Interbank Offered Rate). On the one hand, the PBoC needs to send a clear message that it will not bail out every speculative loan; on the other hand, it can’t afford to see the whole financial system undermined. So it lets the funding markets tighten up for a while, and then injects liquidity just before things get too bad.
How are China’s credit problems relevant to the rest of EM? The problem is that a credit crunch (the lack of available liquidity for new loans) of sorts occurs as shadow loans turn bad. As a result, the Chinese economy slows down. And when China slows, the rest of EM slows too. Many of these countries export to China, so, as a result, their current account balance deteriorates, which leads to capital flight and currency devaluation. Some of these countries, such as Turkey and South Africa, are now hiking interest rates to try to stem the capital flight—but higher rates tend to lead to slower growth. It becomes a vicious cycle.
This leads to two questions. One, could what is happening in China and EM spread to the rest of the world’s stock market? And, two, when do EM equities get so oversold that it may be time to buy?
As to the first question, the Dow recently fell 600 points in two days, so on the surface things look systemic. But perhaps the EM story was just a catalyst for an over-loved U.S. stock market to finally have its inevitable “healthy” correction. We’ll have to wait and see. Certainly, every 5% correction since the spring of 2012 has been “healthy” and has been quickly followed by new all-time highs, which might happen in the coming weeks. I sense that this is the consensus among investors, which is why I think we may get a somewhat deeper correction. After all, if most investors are inclined to ride out this correction assuming it will be short lived, then we may not get the kind of capitulation that usually happens at market bottom until the market goes lower and forces investors to reconsider their bullish stance. This is not a prediction, but it is how the sentiment pendulum tends to swing.
As to the second question, EM looks cheap on a valuation basis. The MSCI EM Index P/E is 12, compared with more than 18 for the United States. But it is also true that earnings in EM have been declining for three years now, while earnings in the United States have continued to climb. So there is a probably a good reason valuations are so low. Beware of the value trap. My sense is that EM valuations will rise only when the fundamental picture starts to improve, and so far there is little evidence of that.
Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.