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Has the bull market run its course?

Despite mediocre earnings growth,mixed economic data,stocks continue to post new highs.

Published: August 12, 2013 12:03:08 am

Despite mediocre earnings growth,mixed economic data and widespread expectations that the commencement of Fed tapering is just around the corner,stocks continue to post new highs. The argument in support of that move is predicated upon the idea that the economy is about to improve,creating an environment that will allow earnings growth to accelerate while inflation remains tame. And besides,the Fed will still have our backs with low interest rates and a bloated balance sheet. Admittedly,this scenario seems quite plausible. The economy should benefit from the dissipating fiscal headwinds of the second quarter,housing continues to improve and jobs are being created. But will it be enough to produce the earnings growth that investors are looking for in the second half? That is the question,as the economic traction story has yet to prove itself.

So far,the data lately has been a little firmer,but not robust. The July jobs report was soft. Second-quarter GDP was better than the first,but wasn’t particularly strong. And as happened with first-quarter growth,subsequent revisions could alter the first estimate significantly. The latest round of purchasing managers reports on manufacturing,and especially services,have been encouraging and suggest that the third quarter is getting off to a good start. But there is a lot more room for improvement before the achievement of second-half earnings targets appears likely. Investors are comfortable so far with the multiple expansion that has lifted stocks to new highs,but will they remain patient if stronger earnings growth does not materialise? There were several recent news items that caught our attention that raise suspicions about the near-term sustainability of this rally. The first of these was a report from the private equity sector in which one senior official after another reported what a great time it is to be selling portfolio holdings. What they are saying is that valuations are more attractive than usual,that the market’s receptivity to new offerings is very accommodating,and that the prices for new investments are too high. They are all better sellers than buyers. If that is true for private equity investors,why shouldn’t it also be true for others? The last time we saw this same level of enthusiasm from private equity was in 2007,when several big players went public. Back then they were better sellers than buyers,and we all know what happened after that.

The second story concerns mutual fund and ETF flows. According to the research firm Trim Tabs,investors committed a record $40.3 billion into US equity mutual funds and ETFs in July. Certainly,some of this activity came in reaction to what was going on in the bond market,while undoubtedly some of it came in response to higher equity prices themselves. And,it should be noted,a lot of money leaving the bond market is flowing into short-term savings vehicles. And it can be argued that equities are still “underowned,” that we have a long way to go before that imbalance is corrected. But anytime the word “record” is involved,it raises the possibility of excess. And the juxtaposition of this news item with the concurrent reduction of net equity exposure among hedge funds is interesting,if nothing else.

The third story concerns a recent interview on CNBC with Yale University professor Robert Shiller,in which he expressed the view that the equity market is showing characteristics of a bubble. In the interview he defines a bubble as “…a situation in which news of price increases spurs investor enthusiasm,which spreads by psychological contagion from person to person,in the process amplifying stories that might justify the price increase…” In fairness,he goes on to say that the current situation reminds him of 1996 when he also warned of a market bubble,which nevertheless continued on for another three and a half years. So clearly,evidence of bubble-like characteristics does not mean the imminent end of a bull market. However,at the very least,their presence should raise one’s awareness.

Taken by themselves,these reports may seem rather benign. And they may prove to remain so. But in the context of a market that is at an all-time high,and with a change in Fed policy possibly just weeks away,they become a little more concerning. Predicting short-term market moves is ultimately a futile exercise. Long-term investors mostly need not concern themselves with them. But it is important to be aware of opposing points of view in order to avoid falling into the trap of consuming only self-reinforcing information.

By David Joy: The author is Chief Market Strategist,Ameriprise Financial.

Views expressed are personal

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