December 10, 2013

Kass: Everybody in the Pool

Investors of all sizes and shapes are nearly all in the pool now. Investor sentiment (in most surveys) is tilted very bullish, mutual fund investors hold near-record-low cash reserves, hedge funds are at multiyear highs in terms of net long exposure, and retail investors (though not at the extremes of 1999-2000) have plowed money into domestic equity funds en masse since the beginning of the year.

Importantly, margin debt, the straw that stirs the market's drink, reached another high in October of $413 billion (up 3% month over month after rising 5% in September). In fact, margin debt is approaching the March 2000 and July 2007 highs as a percentage of GDP. Currently, margin debt is about 2.4% of nominal GDP vs. 2.6% in July 2007 and 2.8% in March 2000.

The many potential headwinds (e.g., Washington shutdowns, geopolitical risks/uprisings, a probable taper, rising interest rates, tepid bottom- and top-line corporate sales and profit growth, signs of ineffective Fed quantitative easing policy, the vulnerability of corporate profit margins, the growing schism between the "haves" and the "have-nots" in a failure of trickle-down economic policy, the consequences of financial repression done for the greater good on the savers class, etc.) have, to date, been ignored and dismissed by stock market participants.

Importantly, the disconnect between the real economy and the stock market has grown more pronounced, as the markets continued their ascent in recent months.

The most recent leg of the bull market started at about 1670 on the S&P 500 (which approximated my fair market value). Since then, the S&P has rallied by over 8%.

Since October, however, the Citigroup Economic Surprise Index has declined from 53 (reflecting a period in which reported economic data substantially outdistanced consensus forecasts) to only 6 recently (as the last two months of economic data have been only in line with consensus).

Taken back to Jan. 1, 2013, Citigroup's Surprise Index has dropped from 40 to 6; at the same time, the S&P 500 rose (year-to-date) by almost 28%.

In "Flawed Case for a Bull Market," I highlighted that the U.S. stock market has been driven by the liquidity of monetary policy, not by the underpinning of domestic economic growth and corporate profits, and that many market metrics are at danger zones: