Teetering economies around the world have investors walking the knife's edge. The industrialized world is running close to stall speed, while the developing world—the marginal driver of global growth—is struggling to transition from its historic reliance on manufacturing exports (predominantly to the growth-starved developed world) to a greater dependence on domestic consumption driven by a rapidly expanding middle class.
By some estimates, this important secular change will lead to an increase in the world's middle class population from somewhere around two billion people today to over five billion in two decades, largely defined by staggering increases in India and China. While this transition is inevitable and important, its implications are longer term in nature, while today's investors have more immediate concerns at the forefront of their minds.
Driving the behavior of current investors is a world devoid of predictable growth engines and suffused with fear of another financial crisis. However, unlike other periods of uncertainty, there is no rational place to hide. The increasingly unattractive return profile for so-called "riskless" assets, such as sovereign debt, presents a genuine dilemma for investors in which one can either accept the inevitable loss in purchasing power associated with bonds or embrace the gut-wrenching volatility of equities.
What's more, asset prices are generally thought to be distorted by the remarkable policy initiatives of the world's central banks. The ECB, the People's Bank of China and the U.S. Federal Reserve, along with numerous other monetary authorities, have embarked on an ambitious path of debt monetization and open-ended liquidity provisions to insure financial stability and to reinvigorate growth. The Fed alone surprised the market recently with QE3, its third round of what is now a multi-year quantitative easing program that plans to purchase an additional $40 billion in mortgage backed securities every month on top of the $50 billion or so of U.S. Treasury Bonds currently being purchased under Operation Twist (part of QE2), until there is an acceptable reduction in the level of unemployment.
These initiatives have been designed to give the economy a boost by further reducing interest rates and injecting vast amounts of liquidity into the U.S. economy; they are policies aimed at bolstering asset prices and encouraging capital formation. Crowding investors out of low-returning fixed income investments would also have the desired benefit of boosting equity prices as money shifts into potentially more productive assets. There is a reasonable amount of evidence that some improvement in employment may have already begun, and when coupled with notable improvements in housing and auto sales, one could venture that perhaps the Fed's policies are making a measurable impact.
To say the least, the bull market has caught many off guard—most investors have not been participating in a run that has seen the S&P 500 Index rise 34.0% and the Russell 2000 Index climb 39.4% from their respective lows on October 3, 2011 through September 30, 2012. It is certainly unusual that a move of this magnitude has not attracted money to stocks. To add to the anomaly, money market funds have regained the peak levels achieved in the midst of the financial crisis, while bond fund inflows show no sign of slowing.
Yet redemptions from equity mutual funds remain stubbornly persistent, which leads to the question, why are so many investors fighting the Fed? Perhaps this longstanding tenet of investing is no longer accorded much consideration. Interestingly, companies are paying attention. Recent JP Morgan research has demonstrated that corporations are actively buying back their own stock. In aggregate, the share count of the S&P 500 ex-Financials has fallen by 3% since 2006, and, with cash continuing to build on corporate balance sheets, this trend is set to continue.
Challenges remain, but two important tail risks seem to have been mitigated in the short run, which should be good for stocks. First is the potential for another recession in the U.S., which we think is unlikely, given the improving economic trends described above. Second would be the potential dissolution of the eurozone, which appears equally unlikely given ECB President Mario Draghi's recent commitment to protect the European banking system and do "whatever it takes" to preserve the euro.
In a nutshell, the world's two most powerful central banks are now open-ended in their liquidity commitments—a fact that should give market naysayers pause. Whether these programs will have unintended long-term consequences is worth considering, but in the short to intermediate term, the equity risk premium should begin to abate from its record high and lead to a positive rerating of the multiples accorded to stocks.
Important Disclosure Information
Chris Clark is a Portfolio Manager and Principal of Royce & Associates LLC. Mr. Clark's thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. The Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The S&P 500 is an index of U.S. large-cap stocks, selected by Standard & Poor's based on market size, liquidity and industry grouping, among other factors. The S&P 500 ex-Financials is an index of U.S. large-cap stocks excluding financial firms, stocks are selected by Standard & Poor's based on market size, liquidity and industry grouping, among other factors..