Moreover, while employment trends continue to be comforting for now, first-quarter economic momentum looks suspect with clear weakness in chain-store sales numbers and a slight month-to-month decline in light vehicle sales. Housing activity continues to improve but overall, the U.S. economy can at best be described as expanding rather than accelerating. The few numbers due out this week should confirm this description, with flat Unemployment Claims, the ISM Non-Manufacturing Index falling relative to January, Productivity registering a sharp decline and both Exports and Imports potentially slipping in December.
Nor should the rally be ascribed to more enlightened policies. In the U.S., a tighter-than-optimal tax agreement on New Year’s Day leaves the economy with significant fiscal drag with the distinct danger of more to come should the parties fail to agree on an alternative way to cut long-term spending to replace the long-dreaded “sequester” now scheduled to kick in on March 1st. Meanwhile the Fed’s continued balance sheet expansion appears to be achieving little in jump-starting lending activity.
The new Japanese government has proposed more monetary and fiscal expansion, but this cannot inspire confidence given the track record of these tools in achieving a Japanese revival over the last 20 years. Finally in Europe, while the ECB has successfully convinced markets that the banks are safe and that it will protect the sovereign debt market, the governments themselves remain on a relentless path of deficit reduction through austerity, which, in a recessionary economy, is normally both painful and ineffective.
What has happened is that “tail risks” have fallen. Over the course of the past year, the danger of a financial collapse in Europe has receded, a “hard landing” in China has been avoided, continued gains in U.S. energy production have reduced our vulnerability to a middle-east oil shock and the New Year’s day agreement, combined with a three-month suspension of the debt ceiling, has reduced the danger of a Washington-produced crisis. As these tail risks have fallen, the “tail valuations”, that is to say the cheapness of stocks relative to the extremely expensive global fixed income markets, has induced investors to move money from bonds into stocks. One sign of this is that the first three weeks of January saw a bigger inflow into stock mutual funds than any month in the past five years. While the pace of these flows is likely to abate, the trend may well continue. The bottom line is that, even with slow global growth, until the world gets a little scarier, equities are likely to continue to outperform fixed income investments.
Nicholas Colas, ConvergEx Group chief market strategist, was also out with a note Monday reflecting on Dow 14,000:
First, it is clear that equity prices (and volatility, for that matter) are much more a direct tool of central bank policy than in prior economic cycles. Second, the rally off the bottom in March 2009 has left the investing world with very few money managers who can legitimately claim the title of “Smart money.” Lastly, you have to consider the way forward. The roadmap from Dow 6600 (March 2009) to Dow 14,000 was – in retrospect – clearly marked by signs labeled “Follow the central bank yellow brick road.” Good enough signage to get us here, clearly. But fundamentals – corporate earnings, interest rates, and economic growth – those are the metrics which will have to guide us as central banks inevitably reduce their liquidity programs.