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The Easy Money's Been Made, Four Reasons for Caution


Fears of 2013 tax hikes and spending cuts, along with uncertainty about early rate hikes, could keep a lid on things for a while.

As someone who was aggressively shorting the market in the spring of 2009, I've learned that one of the worst things you can do as an investor is stay in an idea for too long after it's gone stale.

I'm still looking for the 20%+ year for US equities that I called for last December (see Time Magazine's Choice for Person of the Year Points to 20%+ Equity Gains in 2012), but since we've made more than half that in less than three months, I figured we were due for an update, especially since the environment has changed over the past couple weeks.

Here are four reasons why investors should be less bullish now than they were three months ago:

1. Widespread Acceptance of Normalization

Greece had its credit event and the world yawned. Italian 10-year yields are 200 basis points (bps) lower than they were at the end of 2011 as European contagion concerns have eased for now. Most of the US banks passed the latest round of Federal Reserve stress tests, whatever you think of them, and many are increasing their dividends and share buyback programs. Mainstream economists and pundits are arguing about how strong employment growth will be instead of which European country will default next. This is all good news for the economy, but it means risk assets don't have the uncertainty premium they had in December.

2. Equity Risk Premium Shrinkage

Using a $100 earnings-per-share estimate for the S&P 500 (SPY), the market's equity risk premium has fallen by 130bps year-to-date. Equities, relatively speaking, aren't as cheap as they were. And not just that, but in March Treasury yields have risen more than the market's earnings yield has fallen. Better-than-expected economic data might mean higher bond yields rather than higher stock prices for a while.

3. VIX at 2007 Levels

Along with a shrinking equity risk premium and mainstream embrace of the recovery, the Volatility Index (^VIX) has fallen. In the mid-teens, it's still somewhat above the 10%-11% realized volatility the market has experienced over the past couple months but is well below where it was at the end of December, when the VIX closed near 23. There's still a little room for compression here, especially farther out the time curve as we go into the summer and autumn months, but a lot less than there was.

4. A New, Underappreciated Cause for Concern

Old friend Bennet Sedacca liked to say, "What the market knows isn't worth knowing." And the market knows plenty about Europe, China, sovereign debt, "money printing," and lost decade fears. In the March 13 Federal Open Market Committee statement, the committee noted:
In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions -- including low rates of resource utilization and a subdued outlook for inflation over the medium run -- are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

Which the market interprets as "No hikes until late 2014." Strange, then, that the December 2013 Fed Funds Futures contract is pricing in a 71% chance of a hike by that meeting.

While spring has just begun, my concern is that as the calendar moves toward the slower, more illiquid summer, the market will look for any reason to jump a couple percent to keep traders entertained.

And with economic data continuing to be steady, I could envision a scenario where people say, "Either the economy remains strong and the Fed will have to hike rates sooner than people think, or a post-election Congress means the Bush tax cuts finally expire and 2013 is all about closing the deficit, which will harm growth and hence risk asset prices. Either way, we can't win."

Some amount of that thinking could keep a lid on equities for a while, at least until we get more certainty on the policy front and the winner of the election.

I've been looking for this year to play out in three acts: an early surge, a midyear stall, and a year-end beta rally. I wonder if we're nearing the midyear stall a bit earlier than expected. I suspect the risk/reward situation is roughly balanced for the next four to five months, with perhaps 3%-5% upside and 3%-5% downside between now and August, or a range on the S&P 500 of 1340-1460. Of course, in a post-all-one-market world, individual stocks can and will move much more than that.

So dial back your expectations, pay more attention to Fed comments and the Treasury market for a while, and if you've been waiting for a lull in the action to get to that reading list you've been putting off, now's the perfect time to fly through Tthe Hunger Games series.

Twitter: @conorsen
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No positions in stocks mentioned.

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