On Wednesday, February 26, I had the pleasure of sitting down with Minyanville.com and Buzz & Banter contributor Michael Gayed for an exclusive interview.
Mr. Gayed serves as Chief Investment Strategist for the asset management firm Pension Partners and is one of the most valued members of the Minyanville family.
We've posted a partial transcript of the interview in this article. If you'd like to listen to the entire 22-minute recording, which includes additional commentary on retail stocks, investor psychology, and the dangers of the negative narrative, play this YouTube video:
Michael Comeau: We're going to kick things off with a big question: What makes stocks, as measured by the S&P 500 (INDEXSP:.INX), go up and down?
Michael Gayed: Well, largely it's emotions. The stock market goes through periods of manic movements up or depressive movements down, and when people are making money, that tends to make them take on more risk.
Now the question becomes: Under what conditions does that start, or under what conditions do equities tend to do well?
It's generally when you have expectations of inflation coming down the pipeline. So, as inflation expectations rise, it's historically the kind of environment that encourages people to take risk.
Now the other side of that is when you have inflation expectations falling or you have a growing fear of deflation coming. That's when you tend to see much more depressive states; that's when you see money leave equities in favor of fixed income.
So the long and short answer of it is: What drives markets is emotions, and what drives emotions is ultimately inflation or deflation expectations.
MC: Let's get to the second big question: How do you know this?
Michael Gayed: We've done a number of different studies. We actually have two white papers that, while not directly focused on inflation expectations per se, are focused on things that react off of inflation expectations. Those should be coming out shortly.
This is based on actual testing of market relationships, looking at conditions under which volatility tends to rise. Historically, it's been when you have deflationary pulses. Now over the past, say, 12 to 18 months, we've had a desyncing of that relationship. We've seen disinflationary pressures across the globe, in the developed markets especially, and yet we've seen stocks rise, countering the concept that inflation expectations drive equities. It's been a bit of an outlier, but the longer-term cause and effect is there unequivocally when you look at the data.
MC: I know you do a lot of work on sectors. Is there anything that jumps out at you as interesting right now?
Michael Gayed: Yes, I think energy, among all the S&P sectors, is probably the most interesting. Oil has held around this $90 to $100 range for some time, despite this energy revolution in the United States. And, in general, that's been a very unloved area of the stock market. It's underperformed fairly substantially since 2008, when oil spiked to $147. So looking out from a sector level, I prefer those areas where most people are underweight, because you can make a contrarian trade that there's some kind of leadership change coming.
When you look at broader commodities and the materials sector, there do seem to be some signs of life beginning to show. There's this notion that the supercycle of commodities, which is the idea that China drives the marginal price of any commodity because it's such a big buyer, is over because China is moving away from investment and toward consumption.
But even if the supercycle is over, there are still cycles, and the cycle for energy is probably coming sooner rather than later.
MC: How about housing? The iShares US Home Construction ETF (NYSEARCA:ITB) is up about 6.5% year-to-date, and the S&P is flat. Is that sustainable?
Michael Gayed: It's impressive that housing stocks have done well in the face of some of the more recent data, which have been on the softer side.
But when I look at it relative to the S&P, it's been in a broad range. It has outperformed, underperformed, outperformed, underperformed, but nothing really substantial. Housing overall is key to the reflation story, so you want to see housing stocks lead if you believe in this bull market in equities.
As far as where to position, I still think the housing story is not as compelling as areas that have not participated at all, which comes back to the commodities and emerging markets spaces.
MC: So what's your 2014 outlook for stocks based on what you're seeing now?
Michael Gayed: It seems like the average sentiment is that you're going to see stocks rising but obviously not to the extent of last year, which was very much an outlier.
Now if inflation expectations rise, that's going to be supportive of equities overall, and from a big-picture perspective, that probably does continue to push money out of bonds into stocks.
But the area that will benefit most from rising inflation expectations is probably anything outside the United States.
So that means for the year, you probably could see US stocks up in their traditional 7-10% range. But if that's the case, you could see emerging markets up north of 30%, simply because if you have inflation expectations rising, then you remove this narrative of deflationary pressures. If inflation expectations rise, that means the economy's better and then we're going to buy more from those exporters, so you could see a substantial move in the emerging economies.
If you don't get it, though, then you have a real dilemma that has to be resolved -- which is that US stocks have completely divorced themselves from reflation.
The disconnect of last year has to get resolved either by inflation expectations rising or US stocks falling.
The best-case scenario is inflation expectations rise and pull emerging markets with them.
The worst case is they don't rise, deflationary pressures come back, the markets begin questioning the Fed's efficacy overall, and that causes US stocks to break.
The most likely scenario will likely be inflation expectations rising, but this is a risky juncture because after all these trillions (in monetary intervention), you still haven't seen any pickup in inflation.
MC: We've seen deflation become a popular topic of discussion. Do you think deflation fears are overblown or warranted?
Michael Gayed: I think the answer to that is to ask the Japanese, in the sense that I think there was a growing concern of deflation after the 1989 top in the Nikkei 225 (INDEXNIKKEI:NI225). Those fears were validated, and in some ways, there's this old quote that says that what one believes to be true either is true or becomes true.
So if everyone believes in deflation, what does that mean?
It causes people to then hold off on purchasing something now because they believe deflationary pressures will make items less expensive in the future. If everyone does that at the same time, it creates a self-reinforcing deflationary cycle.
It is unusual to consider that we may not be reentering an inflationary period given that inflation has been the most talked-about topic for decades.
We have to ask ourselves, what's going to reverse it?
If it's a function of psychology, and the Fed has done everything it could, what's going to cause inflation? It may end up being the commodity side pushing prices higher, but again, the supercycle is largely over, so it's not clear.
I think we're in very uncharted territory. Buy and hold, while it seems like it's working now, is probably suspect going forward.
Environments that are consistently deflationary are not favorable for stocks.
If you don't believe me, ask Abe.
Follow Michael Comeau on Twitter: @MichaelComeau
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