2014: Equity Chop & Commodity Hop

Andy Waldock |

I thought taking a vacation at the end of 2013 might allow me to come back to the markets with a clear head and new viewpoint. My hope was that a little detachment would bring the forest back into the picture at 35,000 feet. I’ve now caught up on my reading and research and find the markets just as schizophrenic as they were when I left. While the markets remain as confusing as ever, our trip did provide me with the sense of awe that comes from physically standing in the presence of thousands of years of history. One thing is for certain; mankind always finds a way.

The coming year begins with a stock market that has rallied, virtually unabated since October of 2010 and is up more than 60% since then. The bond market has seen a shift from the safety of Treasuries to the increased risk of high yield funds and a further move in risk to leveraged interest rate Exchange Traded Funds (ETF’s). This final wave comes just as the Federal Reserve begins to withdraw stimulus from the market and long-term rates begin to perk up.  Meanwhile, the typical inflation hedges like precious metals continue to lag with gold more than 35% off of its 2011 highs and silver nearly 60% in the same timeframe. In spite of the large divergence in asset classes, the U.S. Dollar is virtually unchanged from last year.

The confusion doesn’t end with an assessment of the past. January’s equity market headlines have been dominated by calls from Goldman Sachs and Byron Wein of Blackstone calling for 10% drop in the S&P 500 due to its current valuations and the rally that began way back in October of 2010. Investment heavyweights David Bianco of Deutsche Bank and Jim Paulsen of Wells Capital suggest that maybe the equity markets will see 3% growth for the year with lots of volatility and downside thrown in between now and year end. Clearly, the market’s reaction to Friday’s jobs report provided footing for their thesis that earnings multiple expansion is simply about as high as it can go. Friday’s jobs report showed the lowest workforce participation rate since 1978, which gives credence to the notion that the economic recovery we’ve experienced over the last couple of years may be nearing an end.

I’ve discussed the disconnection between the domestic economy and equity market performance at length in the past. Previously, our discussion was based on a weak economy and a strong equity market. This time around it looks like both the domestic and global economies could maintain their footing while the equity markets simply pull back from their over extended levels. The World Bank recently stated that they expect global GDP to grow 30% faster than last year’s 2.4%. This coincides with the Congressional Budget Office’s (CBO) estimate for U.S. GDP to grow by more than 3% this year. Therefore, while the underpinnings of the global economy continue to improve, a stock market correction would still be in play, as valuations get back in sync. Remember, a 10% stock market correction from the current levels wouldn’t even breach the October 2013 lows. Context is everything.

The strengthening economies could create big trouble for the Federal Reserve and bond investors. The Fed has already begun to slow down the stimulus it has been providing to the economy and we’re already seeing a spike in long rates as a result of it. The CBO expects the government’s debt service costs to more than double over the next 10 years, climbing from 1.3% of GDP last year to more than 3% of GDP by 2023. The spike in long-term rates also comes just as the leveraged bond ETF’s have experienced record inflows. Bond funds and fixed income ETF’s have garnered nearly three times the cash inflows of the equity markets since 2007 when the Fed began artificially pushing rates lower in earnest. Spiking interest rates will cause large and rapid losses in these leveraged funds.

Continued growth in global economies will provide a growing need for base goods as well as aspirational hopes of luxury purchases to a newly emerging global middle class. Their growing needs and wants combined with the world’s largest economy (U.S.) finally beginning to pull reserves from the economic system will kick start the velocity of money flows. I think my estimate may be conservative because, even static demand with a declining monetary base creates the same situation. The faster money moves, the more inflationary it becomes. It’s been three years since crude oil made highs, two years for the metals and eighteen months for the grains. I think the commodity markets should be played from the long side in 2014. If I’m wrong, I’ll simply stand back in wonderment as mankind keeps finding a way to move ever forward.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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