Wall Street has fallen into grip of complacency


Serious Money:Equity investors have enjoyed a quite stunning start to 2013 as the major stock market averages jumped by more than 5 per cent in January, and are now within touching distance of the all-time highs registered during the autumn of 2007.

The relentless upward move in recent weeks brings the cumulative gains since last November to more than 10 per cent and a cheery consensus expects the bullish momentum to persist as the year unfolds.

The optimistic stance that characterises most investment commentary is premised on the near-universal belief that a recovery in economic growth will take place in the second half of the year. The bulls believe the resulting boost to corporate earnings that have flatlined of late will justify further gains in stock prices.

There have been few, if any, straws in the wind to back this line of reasoning, but waiting for even tentative signs of a turnaround in the economy’s fortunes from its current lacklustre pace of growth is not seen as an option, given the abundant liquidity perceived as available for investment in risk assets.

Optimism has replaced fear across the investment community: the mantra is maximise allocations to the stock market now to get ahead of the higher prices that are virtually certain to materialise once the trend gathers impetus. The importance of fundamentals has been downgraded and momentum upgraded, as the notion that the current environment is a “win-win” for risk assets gains appeal.

Simply put, the bulls believe meeting or beating expectations argues for higher stock prices, while shortfalls relative to consensus is viewed as unlikely to precipitate any meaningful sell-off because economic weakness provides justification for central banks to initiate further rounds of unconventional monetary policy.

The complete absence of bearish commentary is deafening: even some long- standing bears have changed their tone – complacency has gripped Wall Street.

The tell-tale signs of complacency are there for all to see. The major stock market averages, for example, have not endured a decline equal to or greater than 1 per cent in more than 50 trading sessions, while the CBOE Volatility Index (Vix), a key measure of market expectations of near-term volatility signalled by SP 500 stock index option prices, recently dropped to its lowest reading since the global financial crisis erupted – a level that has been lower little more than 10 per cent of the time over the past decade.

The stock market’s speculative mood is difficult to reconcile with the fundamental picture where both economic and earnings data have continued to fall short of consensus expectations. Indeed, US macro surprises have plummeted to the lowest level since last summer, which confirms that the economy continues to expand at a less-than-stellar pace of 2 to 2.5 per cent.

The growth disappointments are not confined to the US, with recent data confirming that global economic growth slowed to its lowest level since the end of 2009 during the third quarter of last year.

The lack of meaningful growth is more than evident in corporate earnings reports for the final quarter of 2012, with earnings per share, excluding financials, flat year-on-year and more than 6 per cent below the consensus number expected at the start of the reporting season.

Analysts continue to pencil in robust double-digit earnings increases for the second half of the year but, without accelerating revenue growth propelling margins further into record territory, disappointment seems assured.

The bulls will argue that any shortfall in corporate earnings can be absorbed, given the relatively attractive valuations on offer. The stock market currently trades on roughly 15 times operating earnings and 17 times reported profits, with both figures close to historical averages. The consensus contends that higher multiples are warranted, given a 10-year Treasury yield of just 2 per cent.

Should the optimistic arguments that put earnings on a permanently higher plateau prove true, the bulls are still not home and dry. Historical data demonstrates that the stock market has traded on a median multiple of just 10 to 11 times whenever the fixed income benchmark has been priced to yield 2.5 per cent or less.

Complacency has returned to Wall Street, – now is not the time to chase stocks higher.


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