February 1, 2013 8:00 pm

Bulls charge ahead as stocks lift off

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A Cebada Gago ranch fighting bull falls on Estafeta corner during the third Running Of The Bulls at San Fermin festival in Pamplona©Reuters

Bullishness is back. Exuberance is the new cool. World equity markets have had one of the best starts to the year in the past two decades. The US S&P 500 saw the biggest January rise since 1997, and hit a fresh five-year high of 1,511 by lunchtime on Friday in New York after upbeat US employment data. The FTSE 100 had its best January since 1989, when Donna Summer had a UK chart hit with This time I know it’s for real.

The equity rally has put bears on the defensive. But the contest between optimists and pessimists is not over; questions remain over how much further stock indices can rise, whether the rally is simply the result of central bank action, or whether January’s surge has set a classic bear trap for infatuated investors.

The bull case for equities rests, first, on diminished risks of economic disaster. The eurozone has not broken up, the US economy has not fallen over its fiscal “cliff” and China’s economy has not crash landed. Last year’s rally was driven by “worries disappearing, rather than positive news”, says Robert Farago, head of asset allocation at Schroders private bank. “This year, risks are more balanced.” Richard Lacaille, chief investment officer at State Street Global Advisors, says: “We are not forecasting large equity returns, but large enough to justify the volatility risks we see in 2013.”

Second, is a more positive global outlook. News this week of an unexpected contraction in the US economy in the fourth quarter of 2012 was shrugged off as a blip. While political uncertainty deterred investment in 2012, the opposite could be the case this year. “We believe that in 2013, companies are going to put their capital to work. This effect is not really discounted in the market,” says William Davies, head of global equities at Threadneedle.

With the US fourth-quarter earnings season nearing halfway, S&P 500 profit growth is running at 2.6 per cent year-on-year and has been rising since the start of the season in mid-January. “We are hearing a more confident tone from chief executives, particularly on China and emerging market growth,” says John Butters, analyst at FactSet.

Mark Luschini, chief investment strategist at Janney Montgomery Scott, concedes stocks may have got ahead of themselves after a strong start, but “underlying fundamentals look good for corporate profits. We see accelerating growth later this year.”

The third argument of bulls is that 2013 will see a “great rotation” from recession-proof bonds into riskier equities. Equity funds-tracked EPFR, the funds research company, drew $18.7bn inflows in the final week of January – and over the month saw inflows almost three times greater than into bond funds, data showed on Friday.

“From an investor perspective, we know that interest rates at current low levels are not sustainable. That means bond prices are far too high,” says Saker Nusseibeh, chief executive at Hermes Fund Managers. “With shares you are buying access to entities which follow economic growth, pay dividends and are backed by strong balance sheets. Do you really want to lend instead to governments at current levels of debt, or buy corporate bonds, the market for which has already run some way?”

The bear case

Plenty of investors, however, still see reasons for bearish concern. One is the sense of “here we go again”. Optimism has surged in January in previous years – only to decline after a few months. “The equity market is not a great predictor of macroeconomic activity,” says Steven Ricchiuto, chief economist at Mizuho Securities. The S&P 500 is in rarefied territory; in 2000 and 2007 it remained only briefly above 1,500.

“You have to be careful here – the history of holding a full bag in equities above 1,500 has not been pretty,” says William Strazzullo, chief market strategist at BellCurve Markets.

Jack Ablin, chief investment officer at Harris Private Bank, says the January rally has already propelled the S&P to his year-end target of 1,500. While he thinks a move to 1,525 is likely, he is cautious. “We need to see valuation expansion to justify a higher market. The bear case is that the economy is not as strong as we thought.”

Another fear is that share prices – like the world’s advanced economies – remain over-reliant on low official interest rates and “quantitative easing”. With expanding central bank balance sheets, and equity markets shrinking because companies are buying back debt, “those are the sort of conditions in which you get equity price inflation”, says Paul Marson, chief investment officer at Lombard Odier. “It is central bank liquidity that is driving the market. It can only last so long. I’m not convinced of the link between asset price inflation and economic growth.”

Moreover, the “great rotation” may not live up to its billing. Tobias Levkovich, US equity strategist at Citigroup, is bullish longer term on equities, but sees scant evidence yet of retail investors flocking back.

“There will be a great rotation, it’s too early at the moment,” says Mr Levkovich. “Buy stocks on weakness, don’t chase strength.”

Many institutional investors will be constrained in the amount of additional risk they can take into their portfolios, adds Mr Lacaille at State Street. “Yes, there will be a great rotation, but it may not be so great.”

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