For all type of investors, one question for 2014 dominates all others: can the great bull market in risk assets, especially in US equities, continue for another year? John Authers points out that there is an unusually strong consensus in analysts’ forecasts for next year, with almost everyone expecting stronger global GDP growth, dovish central banks and further rises in equity markets. As John says, this “cozy consensus” borders on complacency.
Investor psychology usually reflects the recent past. The year just ending has seen the best performance by US equities in the past four decades, with the single exception of the calendar year 1995. The word “best” in this case does not refer to the highest absolute return, but to the highest Sharpe ratio, which measures the risk-adjusted return.
Strongly positive returns, with very low volatility, is a dream scenario for investors, especially since the stellar performance of 2013 comes on top of several previous years in which equities also rose markedly, though with much greater volatility than seen this year. So is all this simply too good to last?
Past returns do not help us very much to predict the out-turn for 2014. There is no statistical relationship between the Sharpe ratio recorded in any calendar year, and the equivalent figure that will be attained in the following year. There is no tendency for unusually positive Sharpe ratios to come in clusters, and also no tendency for a particularly strong year to be followed by a “payback” year of poor performance. If momentum strategies work, which history suggests they do, they do not seem to do so over calendar year periods.
Nor are valuation signals are very helpful in picking the top of a bull market, except when they are at extremes.That is not the case at present.
US equities are somewhat expensive compared to their own history (in Shiller p/e terms, for example), but are still very cheap relative to bonds; and euro area equities are cheap relative to the US, as long as investors are willing to believe that profit margins in the euro area can rise as the recovery proceeds.
Research on identifying bubbles by new econometric techniques (which I will write more about in the near future) is also re-assuring. It suggests that the probability that the US equity market is currently in a bubble is less than 20 per cent .
In the absence of egregious over-valuation, we need to look elsewhere for signals that the market may be near a major peak. One of these would often be an over-stretched economy. But the current cycle may be even more difficult to predict than normal, because the economic and policy back-drop for the bull market is so unusual. The deviation between actual and trend output in the developed economies is unprecedented since the 1930s, and the monetary policy response to this development is unprecedented, ever.
While we do not know how all this will end, we can at least identify why the bull market has occurred. The developed economies have been operating with a wide margin of spare capacity, so inflation pressures have been non existent. GDP growth has been positive, allowing profits to grow strongly, but not positive enough to threaten the supply potential of the major economies, despite the fact that estimates for potential have been revised downwards compared to previous long-term trends. Slow but positive GDP growth has proven a very benign mix for equities.
Central banks have become increasingly alarmed at the wastage of economic resources, and have worked very hard to reduce real bond yields, which are the discount factor used in equity valuations. Whether the defining element in central bank activity has been outright asset purchases, or aggressive forward guidance on short rates, is so far unknown, and will be a key issue as the Fed tapers in 2014.
An important signal that the bull market may be vulnerable will come when this constellation of factors begins to fray at the edges. With inflation still falling to uncomfortably low levels, there is no sign yet that the developed economies are approaching their capacity ceilings. But many forecasts for GDP growth in the advanced economies during 2014 now show the growth rate exceeding trend for the first time since 2010.
With estimates of potential GDP being trimmed further, in response to very low rates of capital investment and signs of permanent damage to the labour supply, the margin of comfort between actual and potential GDP may begin to be eroded for the first time during the bull market:
The above graph shows the consensus projection for real GDP in the next two years, as well as the latest IMF/OECD estimates for potential output. On the central projection (light blue), spare capacity will not be eliminated before the end of 2015 at the earliest, which is encouraging for asset markets.
However, the 90 per cent confidence interval around the growth forecasts shows that an accelerating recovery in output, presumably led by the US, could result in G4 output bumping into the estimate for potential GDP within a year or two from now. That might seem improbable, but a few months ago it seemed highly unlikely that the UK would suddenly start growing at a 5 per cent rate. A similar period of catch-up growth is not entirely out of the question in the US.
Of course, there is not only huge uncertainty around the central growth projection, but also similar uncertainty around the estimates for potential output as well. It is possible, as the Fed and the Bank of England (but not the ECB) seem to think, that a rapid recovery in demand will succeed in pushing potential output upwards towards the long term trend (red line). Let us hope so, because this would obviously be excellent for the economy as a whole, not just for asset prices.
What does this analysis imply for equities in 2014? The key bull factors which have under-pinned the market for five years still seem to be in place, though the expansion of central bank balance sheets may slow down somewhat as the Fed tapers. Assuming that tapering has now been built into bond yields, this may not be enough to end the bull market.
But if the Fed begins to show any real sign of concern that US GDP is bumping up against potential, that would be another matter entirely.
 It is important to remember that equities can be over-valued, and subject to declines, when they are not in a “bubble” according to these methods.
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