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.