After his trip around the world to visit his managers and study market conditions, Mark Yusko, founder of Morgan Creek Capital, came back with a decidedly bullish view. Mark Yusko thinks that the outlook for financial markets is pretty balanced, with threats and opportunities. Among the threats are above average valuations, slowing EPS growth, investor complacency, deterioration in macroeconomic fundamentals, possibility and extent of Federal Reserve tapering, and slower global GDP growth. Mark Yusko is particularly concerned about the impact of central bank liquidity on asset prices; they see such liquidity as crucial to the markets. The price drop on all asset classes, particularly bonds, at the end of the second quarter showed the negative impact of removing liquidity before the economic recovery and fundamentals can support asset prices.

Mark Yusko

Mark Yusko on frothy U.S equity markets

Morgan Creek Direct, which is a best ideas portfolio, was up 5.7% in July alone, and has gained +11.3% in the period from May-July, outperforming all major benchmark indices. Mark Yusko says that the highly concentrated Direct portfolio outperformed markets in Q2 and exhibited less volatility compared to the turbulent markets of May and June. Morgan Creek’s flagship Global Long/Short Equity Fund was up 1.4% in July and has taken a +7 return YTD.

Take a look at Mark Yusko’s comments from the Q1 letter.

Mark Yusko again takes some time to talk about the fundamentals—defying rise of equity markets, he says that the only explanation is that people are just buying on the trend because everyone else is buying. He writes:

“As usual, we have seen this movie before (and it has never ended well) and it is likely that the five most dangerous words in investing, “it is different this time” probably don’t apply now either. The problem is always one of timing when things will return to normal once they have broken away from normal, that is the most challenging part of investing.”

Mark Yusko says that the thesis that Bernanke has got your back is more applicable in Japan, so it is better to remain overweight in equities there rather than in the U.S. On the subject of Europe, Yusko noted:

“The Core markets in Europe have stemmed the bleeding and are creeping back toward growth, primarily because they didn’t have to “take their medicine” of Austerity and with continued government fiscal and monetary stimulus, there is a heartbeat of growth. The Peripheral markets in Europe are still bleeding and growth is a distant goal (despite all the rhetoric coming out of Brussels to the contrary), precisely because they “had to take their medicine” and, like some forms of chemotherapy, the drug was worse than the disease.”

Mark Yusko sees long term support for equities

On the other hand, Mark Yusko noted that developed equity markets were marking new highs. Morgan Creek’s team postulated that earnings yields are making stocks look attractive compared to other investments like bonds, expectations for 2014 EPS were still being raised, and that low market volatility warranted investor complacency. Yusko also believes that macroeconomic data is mostly backward looking, and that even though GDP growth was slower it was still positive. Such growth could support equities in the long term. Equities in Japan and the U.S. have a slightly better outlook than emerging markets. In Yusko’s view, this is due to the negative impact of weaker yen on Asian exporters whereas the stronger U.S. dollar has negatively affected countries with a large current account deficit like Brazil and South Africa.

Mark Yusko talks about his meeting with a specialist portfolio manager in Japan who was of the view that, “the party is just getting started, and most investors are under-informed, under-invested and under-enthused about what is happening in the third largest economy in the world, which bodes well for future equity returns.” Yusko it seems agreed with this view of Japanese economy.

Mark Yusko bullish on Japan

Mark Yusko is particularly bullish about Japan; he sees the TOPIX reaching 1,600 over the medium term and the Nikkei reaching 20,000 by 2014. Factors supporting potential gains include incentives in Japan for consumers to spend, including new consumption and potential inheritance taxes, cheap small cap companies that are priced below their cash value offering potential for gains, a rebound of companies like Sony and Panasonic that are sharing gains with their employees in the form of bonuses, and attractive pricing of Japanese equities relative to other developed markets, like the U.S. On a market capitalization/GDP basis, Japanese equities are trading at 80 percent in the fairly priced zone while U.S. equities are trading at 115 percent bordering the significantly overpriced zone. The market capitalization/GDP measure is one of the favorite valuation indicators of Warren Buffett.

Risks to Japanese economy

Some risks for Japan’s favorable outlook, according to Yusko, include strengthening or no more weakening of the Japanese yen (level not going above 120), no demand from Japanese institutional buyers and dwindling demand from leveraged international speculators. Other risks would play out if inflation spirals out of control hurting economic growth and becomes driven by higher costs instead of higher domestic demand, and global economic GDP declines making the U.S. dollar and the yen safe haven currencies again.

However Mark Yusko sees the likelihood of the yen strengthening as low, as the currency is trending towards 140. It is unlikely that inflation will spiral out of control, in Yusko’s view, as Japan’s monetary system is closed. However, the risk of a global slowdown is higher and China could drive the yen higher for its exports to better compete against Japan’s.

The full letter is embedded below:

2Q2013 Market Outlook Morgan Creek Mark Yusko