With discussion of market crashes seemingly abundant over the past year – and much focus uniquely centering on algorithmic factors – Omega Advisors has a logical message of hope. No, the world isn’t perfect, they note in their July 22 letter to investors reviewed by ValueWalk. But looking at markets from a fundamental standpoint, the analysis of Leon Cooperman and Steven Einhorn didn’t see any of the five bear market checklist points present in today’s market environment. “If the U.S. equity bull market is to end soon, it will be among the oddest and strangest endings to a U.S. bull market in the post-war period,” the pair wrote in a letter first reported by Rachael Levy of Business Insider.
It is at this point in history fundamental economic market outlooks meet the new algorithmic market environment reality. If the markets do “end soon” without the Cooperman and Einhorn bear checklist occurring, will it benchmark the moment algorithmic / technical factors and not economic fundamentals overwhelmed free markets?
Cooperman and Einhorn base their positive stock market thesis on five traditional economic factors
There are five points that Cooperman and Einhorn look for to determine if a bear market is approaching. These are not factors pulled out of a hat, but rather a study of economic history and the thesis rooted in core economic logic. First the duo note:
With respect to the U.S. equity market outlook, as our readers know, we have been constructive. Though a short-term correction in U.S. shares would not be surprising, nor would a several month pause, we remain okay with U.S. shares. We have expected U.S. shares, as represented by the S&P 500, to deliver a total return of between 5% and 8% this year. Year-to-date, the S&P 500 has delivered a total return of slightly over 6%. U.S. shares are within a few percent of our expected total return for this year. Nonetheless, we are not inclined to reduce our U.S. equity exposure for, as we will see, our portfolio has a lot of value in it relative to the S&P 500, we expect our “kind” of stocks to take on leadership within the market, and we expect the in-place S&P 500 advance itself to extend for quite a while longer, delivering a total return akin to our expectations for 2016. First, and foremost among our reasons for not raising cash in our portfolio is that our portfolio has underperformed the S&P 500 and is, we firmly believe, chock full of value. Second, the okay to acceptable macro landscape we envision should, as we detailed earlier, bring investors to a risk-on mentality where more cyclical/complex/higher beta/higher volatility/less bond-like companies take on market leadership. Our portfolio is focused on such names. Notwithstanding these comments, which favor our portfolio, the S&P 500 outlook is important and critical in assessing prospects for our portfolio. Because our portfolio has a substantial long net bias, a friendly S&P 500 is a near requirement if our portfolio is to generate a respectable return. Even though the year-to-date S&P 500 total return is within a few percent of our expected return for this year, we continue to believe that the S&P 500 outlook will be a friendly one, even as U.S. shares may pause for a while. Why? Because we expect that the in-place U.S. equity market advance can last for quite a while longer than this year. Though we understand the difficulty in offering up a longer-term market outlook, particularly given the geo-political uncertainties and challenges surrounding the U.S. and other regions, our assessment of fundamentals suggests that U.S. shares should grind higher through 2017 and, perhaps, in the years thereafter. Our constructive view of U.S. shares is not so much based on our expected return in the remaining months of this year, which is likely to be modest, but rather on the expected duration of the market’s advance. The expected persistence of the U.S market advance is what keeps us with U.S. shares and this S&P500 underpinning is critical to the performance of our portfolio. If we did not believe that the S&P500 could sustain an advance for an extended period of time, we would raise cash, notwithstanding the positive characteristics and valuation of our portfolio names. Bullishness on any market is drawn from a combination of price expectation and duration of advance; at the current time, our encouraging stance on U.S. shares is more a function of the expected duration of the in-place bull than it is price expectation over the coming several months. We would not object to being characterized as neutral for now, bullish after a pause where U.S. shares mark time for awhile.
While we have a favorable view of U.S. shares based on our expectation of an extended period of advance for the S&P 500, there should be no mistake that there are risks surrounding a constructive outlook for U.S. shares. These risks include the following: central banks that may be out of bullets and unable to stimulate weak economies and inflation; the potential that investors lose confidence in the effectiveness of global monetary policy; excess capacity in oil and other commodities which can pose a deflationary threat to the global economy; an opaque China economy subject to abrupt changes in currency policy and inadequate communication with markets; a risk that the Federal Reserve falls “behind the curve” as it focuses on fragile non-U.S. economic growth and volatile financial conditions in addition to its defined dual mandate of stable inflation and full employment; weak Euro area bank fundamentals, Euro area bank capital adequacy questions, and the extent and implications of Euro area non-performing loans on credit growth; Brexit and the implications of it for the U.K. and Euro area; the unsettling presidential landscape in the U.S.; geopolitical risks; asset market illiquidity and the price volatility this brings; and the significant debt build-up in the U.S. with ever less benefit to economic growth (Figure 6). Several of these risks will be discussed later, specifically, the Brexit shock, a China hard landing/yuan devaluation, exhaustion of central bank bullets to stimulate economic activity/inflation, the threat of protectionism to global trade, destabilizing currency movements which can spread volatility to financial markets, and misallocation of capital owing to unusual global monetary policy.
The first factor they consider is “accelerating and problematic inflation.” Currently central banks around the world are engaged in contortionist monetary gymnastics to ignite inflation. Cooperman and Einhorn accurately note that inflation is not yet approaching, but all eyes will be on Japan as they potentially engage in yet another new and untested monetary experiment, known as “helicopter money.” That derisive slang refers to what has been called a “historic” combination of monetary and fiscal policy.
No, inflation is not around the corner, so Cooperman and Einhorn can check this box. But they also might do well to consider current anomalies in history.
Algorithmic and quantitative factors are driving market environments as never before. Interest rates are negative in some regions, intentionally held down like a kid in a pool gasping for air after being submerged in the water a bully. The concern is that the breaking of traditional economic market principles for too long and being too harsh will have a cost. This is the new algorithmic market environment. While inflation might not be nigh, deflation in the face of historic central bank intervention might be a new factor to consider in the formula.
In their analysis Cooperman and Einhorn point to monetary intervention's influence in correlated markets when they note the “disconnect between our treasury bond yields and economic activity.” This linkage is a key concept. In free markets bonds were used as a tool of price discovery that delivered economic clues. That no longer exists and astute investors should duly note the persistent of this recent trend.
The economy is generally running at acceptable levels, the letter notes. But something is amiss in the bond market force. “The term premium does not reflect or measure the impact of economic activity or inflation as they affect the 10-year yield.”
Welcome to a market environment that is distorted by historic intervention. These are no longer free markets. The question is: how long can this last? Such concerns are algorithmic in nature and not traditionally included as part of the fundamental territory. In a world of negative interest rates, consider that deflation can be as negative or worse than the threat of inflation. Inflation signals strong demand, deflation has a more ominous message.
Central banks are not hostile and Yellen is "friendly"
The second checklist component is “very tight/hostile monetary policy.” Cooperman and Einhorn are looking for potentially two rate hikes in 2016 – with September again being on the table. Here Cooperman and Einhorn demonstrate literary flare as they make in important point that Balyasny Asset Management recognized last summer:
“Bull markets and economic expansions do not die of old age; they are murdered by central banks.”
Central banks are not ready to “murder” this bull market, is the analysis. The Omega letter called the current regime under Chair Yellen “friendly” to markets. Brexit remains a long term uncertainty, banks in Europe are undercapitalized, capacity utilization is not near the area where sustained tightening might be expected. No need for the Fed to get "hostile."
Yellen has been friendly to markets. She generally isn’t given the credit she deserves for initially pulling the dependent needle of stimulus out and engineering a higher stock market. Looking at markets in 2015, this appeared as a daunting task that appears to now, with a relative degree of success, the concern seems to have been brushed aside without appreciation for the task at hand.
In an algorithmically driven market environment, how and when central banks withdraw from simulative market influences can have consequences. Just the talk of monetary withdrawal sent markets reeling in August 2015, which was a technical market crash that was for the first time predicted by a derivatives analyst. These factors are typically not considered in traditional economic analysis.
Investing against popular opinion when the prospect of recession is low
There are two indicators of a coming market value readjustment that Cooperman and Einhorn say should be present, factors which are often negatively correlated to one another. When the prospect for inflation is low and investor exuberance – mainstream popularity – is low, this is an opportune moment to have long exposure to stocks.
Currently the prospect of recession is considered low while investor exuberance is in roughly the same state. When both indicators are high it has, in the past, correlated with a negative stock market environment.
“We have been of the view for quite some time that the U.S. is in the midst of a very long-lasting economic expansion where recession risk is modest,” the letter says, pointing to a litany of factors associated with a reasonably strong economy. Pent up demand, for instance, is pent up and US manufacturing, a significant issue in this ugly presidential election cycle, is starting an uptrend and look attractive.
“The sheer number of aggregate economy metrics which are consistent with a long-lasting U.S. economic expansion (see below) gives us a high degree of confidence in the notion that the current U.S. economic expansion is not in jeopardy anytime soon,” Omega predicted.
Equity price is tied to bond yields, but do bond yields reflect reality?
To end its checklist, Cooperman and Einhorn consider relative value analysis across two of the more important assets: Speculative equity market pricing relative to interest rates and inflation.
From an investment standpoint, the relative return one can find in bonds has traditionally correlated to the price earnings ratio investors are willing to pay for stocks.
“We are not of the opinion that equity market valuation is speculative, and we do not think valuation will deter or derail the in-place U.S. equity market advance,” they predicted. “A large number of valuation metrics are not at all problematic relative to history and prior bull market peaks.”
While price / earnings ratios might be high on a historic basis, it should be considered on a relative basis. Cooperman and Einhorn note that when compared to interest rates at negative levels, stocks look affordable.
Considering the new algorithmic reality and Omega's analysis in this letter provides an interesting angle. While Cooperman and Einhorn are accurate that the relative value comparison between stocks and bonds is in a normalized range, they also point out early in the report a key truth: bond prices have disconnected from economic reality. Bonds are no longer a measure of economic strength, which is related to how the stock market is valued. When markets are heavily influenced by players without primarily economic motives, the performance drivers and market environments react to different stimulus.
This is the new algorithmic market environment. It is this new reality that should be understood alongside, working in partnership with, traditional Wall Street economics.