We've only just begun

It’s natural for investors to question what has been a fairly decent equity rally over the last 12 months.

Global markets experienced the best January since 1989 in some cases, and for the All Ords it was the second-best January since 1994 (with a gain of 5.1% – just behind the Dow at 5.7%). Some investors consequently suggest the market has run ahead of itself – that fundamentals or earnings don’t support the rally. Instead, it is weight of money (or liquidity) that is driving this market, with the implication that the rally has no legs or that it is somehow irrational.

I can’t say I agree with that viewpoint. In my opinion it is simply wrong to suggest that there is some disconnect with the fundamentals locally. Don’t forget that the domestic market is still some 40% below its 2007 peaks. This, when our banks and miners are recording revenues 50% above 2007 levels. Some of our large retailers are 30% above. Valuations are reasonable, quite frankly, and you can see this most clearly in the trailing price-to-earnings ratio (forecasting errors make this my preferred measure as it reflects actual results). If there was some disconnect between market pricing and the fundamentals, this would be evident in that metric. But it isn’t – the P/E ratio (All Ords) at 15 is about average – see chart 1 below.

Click to enlarge

This is about what you’d expect for an economy that is travelling around trend overall – with a low unemployment rate and trend employment growth. Indeed, I’d go so far as to say that weight of money has had very little to do with things at this point. If anything, and with a valuations now around average, I think all we’ve seen to date is a modest unwind of the extreme risk aversion that weighed on our market.

Earnings forecasts may be heading south, but I suspect these forecasts are wrong. Just look at the solid results we’ve seen from some key retailers just this week – Wesfarmers, Woolworths and Kathmandu. Iron ore production is at, or near, records etc. I would suggest instead that the underlying macro views underpinning these pessimistic earnings forecasts are wrong, as they have been for years now.

Now weight of money – or the “Great Rotation” – is going to be a powerful global phenomenon. I don’t doubt this. But the truth is, we haven’t even begun to see it in operation – and you can see this most clearly in the US (Admittedly the chart only shows data to the September quarter of last year, but most of the gains made over the last 12 months had been made by then and so it still gives a good guide as to what was driving the rally.)

Look at the chart below. It shows that there is still a significant proportion of wealth that is held in cash, bonds and cash-like investments.

Click to enlarge

All the chart shows is that US households (directly and indirectly through pension/mutual funds/retirement accounts) are normalising their asset allocation following an extreme bout of risk aversion that occurred around the GFC. Indeed, at 25% of total financial wealth, holdings of cash and bonds are still slightly higher than average – and someway from the low of the last couple of decades (of 19%). Cash deposits themselves are still higher than the pre-GFC average (of 14%) at 16%. This isn’t consistent with the weight of money argument, – or some great rotation – which implies that households, and through them pension and mutual funds, are dumping cash and bonds and piling into equities. The evidence shows they haven’t been dumping or piling – just slowly normalising.

Equity holdings themselves, held both directly and indirectly through mutual or pension funds (who collectively hold about 20% of household wealth in total – cash, bonds and equities) are at 38% of total financial wealth, which is about average. Again, I’m not seeing anything unusual about that – anything to suggest the stockmarket rally reflects an irrational flow into risk. People are still, by and large, quite cautious. Look back at chart 2 above – at the 2007 peak, stocks comprised about 42% of wealth, while in 2000 that was up near 50%. That’s what we’d be seeing if weight of money was in fact an issue. Weight of money to me is a force we’ve yet to see.

I would view the equity rally to date – the period 2009-2012 – simply as phase one. That is, risk appetite is normalising after an extreme risk event, and phase one still has some way to go as mentioned. Phase two will be when we begin to truly see the influence of weight of money. This is when the asset allocation normalisation process turns into a hunt for yield, and cash and bond holdings are cut (potentially aggressively).

If the proportion of financial wealth allocated to bonds continues to normalise (to 22% or 23% of financial wealth), this alone could add $1.5 trillion to US equities – or about another 10%. That’s just normalising. If investors suddenly decide that earning nothing on cash and bonds isn’t that great after all and reduce that weighting even further, to say 20%, that would add another 10% on top of that – for a 20% gain. That’s without even trying, and would be nothing unusual. The fact is, though interest rates are at their lowest on record, it wouldn’t be unusual in that environment if cash/bond allocations then fell to 10-15%. This would free up about $13 trillion to invest in the stockmarket – and that is going to reflect the weight of money.

Recall that through 2010-2012 it took all the confidence-destroying power of a Eurozone collapse, the 90% chance of a “grexit”, the 70% probability of a US double-dip, and all manner of other extreme events to contain the weight of money and buttress global bond and cash holdings. Still, these weren’t bad years for risk, and all throughout investors continued to normalise their asset allocation.

With that in mind, I don’t think (if analysts are correct in thinking earnings will be softer this year) that period of sub-trend economic or earnings growth would even be sufficient to contain the hunt for yield. We’d need to see some truly horrific outcomes, or fears of them – as we did over the last three years – to do this.

So, summing up, the equity rally to date (domestically and abroad) has been entirely driven by fundamentals. It is a correction from extreme GFC-induced risk aversion. The truth is that weight of money hasn’t even begun to show itself – this fact, and the sheer magnitude of money that is available to shift into equities, means there is still significant upside to the stockmarket.

This remains the case (in a zero interest rate environment), even if, as some analysts suggest, earnings should disappoint or soften.