An interesting piece by Gerard Minack at Morgan Stanley today which provides some pointers to how to think about investing in such distressed and unusual conditions. Minack notes what has become obvious in a world with such low interest rates: that the customary relationship between interest rates and the stock market has been broken. Lower rates no longer imply a higher stock market. If anything, low rates are acting as a signal to scare investors even more, as of course has happened for over tow decades in the Japanese stock market, surely now the longest bear market in modern history.
Minack is surely right when he says the markets are in a new phase. What worked for the last three decades or so will not work in the next:
In many ways the past 30 years will be no guide to the next decade, in my view. One example is the response of equities to rate changes. Through the credit super cycle there was often a clear inverse relationship between interest rates and equities: rates down, equities up. This link was independent of the effect of monetary policy on the real economy: policy affected valuations.
In theory, Minack’s argument should favour value investors, not asset traders. Investing in companies that genuinely increase the value of their businesses, rather than securities that go up and down on high octane, leveraged sentiment:
Contrast Exhibit 2 with Exhibit 3, which shows the 15 years preceding the credit super-cycle. Here there is high correlation between the macro cycle and equities. This is not evidence that there is a long-run correlation between growth and equity returns – there is not. Most of the period covered in Exhibit 3 was a bear market, because of rising inflation. The point is that cycles in the equity market – disregarding whether the secular trend is bullish or bearish – are often driven by interest rates in a leveraging phase, but are typically driven by growth in a deleveraging phase.
Of course, there is not much growth around in developed economy markets at the moment, so investing is looking a little dodgy, to say the least:
We are now clearly in a deleveraging cycle. That means that equities are again focused on growth indicators. Exhibit 4, for example, shows the correlation between US equities and initial jobless claims. I am not saying that nothing else matters; clearly global markets are now focused on events in Europe. But the point is that the major directional moves in equities in a post-bubble environment are driven by growth.
Of course, to the extent that monetary policy can affect growth, it can affect equities. The argument is that in the credit-super cycle, monetary policy often did not affect risk assets via its effect on growth, it had a direct impact on valuations. In fact, when the boom was in its pomp, equities would often weaken on good growth news on the basis that it signalled higher rates. Good news was bad news.
Now, however, it’s obvious that good (macro) news is good news for equities. The bottom line is that there is now a strong positivecorrelation between rates and equities: lower rates go hand-in-hand with lower equities. This has been the case since the equity bubble peaked in 2000 (Exhibit 5).
The implication is that the “Greenspan put” is well and truly dead, at least in the stock market. Sadly, however, what should be happening as a result is not. Rather than return to real value, equities have become completely beholden to the latest tick either way in macro data and the traders now rule over a machine that generates returns exclusively through volatility.