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Leadership is a crucial quality. For the first time since the financial crisis, the January stock market rally suggests the economy will achieve escape velocity in 2013.
Leading the bullish performance this month are sectors that are barometers of the economy’s future prospects, with financials, materials, energy and consumer discretionary shares up strongly.
Definitely heartening for bulls is the performance of transport stocks this month, with the Dow Jones Transportation Average up about 10 per cent and at a record high, handily outpacing the S&P 500’s gain of about 5 per cent.
That said, the broad market’s performance is nothing to sneeze at. The S&P is on pace for its best January since 1997’s heady rise of 6.1 per cent.
Such optimism is being accompanied by volatility sliding to its lowest level since mid-2007. Meanwhile, money has started flowing back into equities, suggesting the past five years of outflows from mutual funds may finally end this year and affirming the sense that 2013 may be the start of the “Great Rotation” out of bonds into stocks.
Underlining that theme, corporate earnings, while not spectacular, are doing better than forecast, with executives sounding a lot more optimistic. Stepping back, the macro picture is also brightening with the eurozone firmly in remission from its debt crisis. China is reporting stronger growth while Japan, the world’s third-largest economy, finally appears serious about reversing decades of lacklustre performance.
There was also better news out of Washington this week, with a vote by the Republican controlled House to delay a showdown over the debt ceiling until May, reducing anxiety over another fiscal showdown.
So for a host of reasons, the performance of equities may have further room to run with the S&P’s record peak from 2007 in sight.
Looming large is the central role of the Federal Reserve. Three plus rounds of quantitative easing since late 2008 have delivered startlingly low Treasury, mortgage and now top-rated corporate debt yields. It has also pulled average yields on junk-rated debt well below 6 per cent.
In turn, central bank pump-priming has driven a big recovery in equities from their nadir of 2009 and that now may be distorting their message.
Alan Ruskin, of Deutsche Bank, contends: “The bearish view is that central banks may be driving liquidity to equities in a way that makes equities a much less representative metric of future growth, but this goes against a long history and many cycles where equities have been among the most reliable leading indicators of growth on a three to six month ahead time horizon.”
As the equity bull run enters February, and investors focus on the next monthly jobs report, the nagging question for bulls will be whether all the positive news has been largely priced into equity prices. That could leave the market vulnerable to a spring time pullback.
A greater concern being stoked by the markets’ current performance is what happens to asset values should the economy move into a higher gear this year.
Currently, low yields do not accord with the economically bullish performance of equities, but this divergence is being held in place by the Fed’s aggressive bond buying.
The key factor is how long can the Fed continue suppressing bond yields should the economy accelerate and inflation pick up as the jobs market tightens.
“The moment the Fed takes away the security blanket will be a test for the market; we should see higher volatility and interest rates,” says Jay Mueller, portfolio manager at Wells Capital Management.
An orderly rise in bond yields should not unduly impair equities against the backdrop of a growing economy.
Michael Hartnett, of Bank of America Merrill Lynch, warns that the coming transition between equities and bonds may be a rough ride.
“The two major risk scenarios to an orderly Great Rotation are: a bond crash as in 1994; a risk shock as in 1987, driven by a currency war,” he said this week.
A true test of equity leadership awaits.
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