Birth of a New Cyclical Bull?
BIG PICTURE - "Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria" - John Templeton, Founder of Templeton Funds
The coming year may go down in history as a bullish one. After the shocking asset-liquidation witnessed in 2008, the following 12 months are likely to provide above-average investment returns. Given the negative economic news and awful investor sentiment, my assessment may sound absurd but it looks as though the bear-market ended late last year and we are now in the early stages of a new cyclical bull-market. Below are some of the reasons why I believe the skies are clearing for a 4-5 year bull-market:
- Surging liquidity - central banks have pumped trillions into the banking system
- Low-interest rates - yield on cash and cash equivalents is at a historical low
- Declining corporate bond yields- risk appetite is returning
- Declining Ted Spread - inter-banking lending rate has declined, a positive sign
- Low valuations - various stock markets are trading at very attractive multiples
- Horrendous investor sentiment - a contrary bullish indicator
- Volatility has peaked - VIX has topped out and is falling
- US Dollar rally has ended - bullish for the markets
- Global stock markets are making higher lows - sign of base building
- Huge amount of cash on the sidelines - US$8.85 trillion or 74% of US market cap
Now, I am well aware that the above prognosis goes against the mainstream bearish view. After all, most professional and amateur investors are very worried about the state of the global economy and many are expecting a horrendous economic depression. Furthermore, according to some prominent bears, our world is heading into a deflationary bust and the Dow Jones Industrial Average is about to contract by another 50-60%.
For sure, anything is possible in the business world, but at this stage, a 1929 style economic depression is out of the question. Back then, the US economy contracted by a whopping 46%, unemployment went through the roof and thousands of Americans lost their entire savings as roughly 10,000 banks went bust. This time around, the US economy has barely shrunk, the unemployment rate is not even close to the 1982 recession and not a single person has lost money due to a bank-run. So, at least the current circumstances do not warrant a prolonged economic depression.
Let there be no doubt that the US economy is certainly struggling - housing starts, permits and home sales are at multi-decade lows, auto-sales have slumped, retail sales have contracted, unemployment is rising and manufacturing is at the lowest level since 1980. Despite all these negatives, the state of the world's largest economy is still nowhere near as bad as it was during the Great Depression.
It is interesting to note that Professor Nouriel Roubini (who correctly forecasted the extent of this economic slowdown) was recently interviewed by the Financial Times. During the interview he stated, "We are going to avoid the Great Depression and a severe recession even if there is a risk of protracted slow economic growth".
If Professor Roubini is correct about the economy, then I suspect global equity and commodity markets will see explosive moves from the current levels. We must remember that the investment community is manic-depressive and most participants have already factored in a gut-wrenching economic recession or worse. So, if the current recession does not morph into the widely expected prolonged depression, investors will have to re-think their investment strategy and this will be the catalyst for a powerful rally. Given the dismal yield available in cash and government bonds, when investors search for higher yields, capital will flow towards the beaten down equity and commodity markets. At the same time, US Treasuries will witness a spectacular crash. Figure 1 shows the astonishing decline in the yield available on 3-month US Treasury Bills.
Figure 1: Yield on US Treasury Bills (1941- present)
As the financial crisis worsened over the past year, a growing number of investors parked their money in the 'safe haven' of US government bonds. This massive inflow of capital pushed up the value of US Treasuries and drove down the yield to almost zero.
In my view, US government bonds are now grossly inflated. I have no doubt in my mind that when global stock markets show further signs of a recovery, investors who are holding these overvalued US Treasuries will look for a higher return on their capital. And everybody will look to exit through the same crowded door. This selling mayhem may cause an epic crash in US Treasury Bills and send the yield sharply higher (Figure 1).
Over in the precious metals department, so far gold has fulfilled its 'safe haven' role by holding up relatively well in this post-bust environment. However, if my assessment about a recovery in equity and commodity markets is correct, it is possible that gold may under-perform other assets over the following months. Now, I am not saying that you sell your gold bullion but at this juncture, I prefer the hardest-hit industrial metals, silver and platinum over gold. Those metals which suffered the most over the past six months are likely to rebound the most in the ongoing recovery.
In summary, I maintain my view that global equity and commodity markets put in important lows in the final quarter of 2008 and we should see big upward moves in the months ahead. So, I would suggest that you hold on to your positions in commodities, commodity-producing companies and precious metals as we pass through the bottom of this business cycle.