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Don't Stop Believing in US Equities: This Time Might Be Different


There are some different dynamics in place to sustain this bullishness longer term.

Everyone it seems, from my view at least, is so bearish on equities. Yes, the Barron's cover last weekend may have read Dow (INDEXDJX:DJI) 16,000, but between the lines we read of corrections to bear markets. People even pointed out the history of Barron's covers as a contra-indicator. Well, those same people probably believe in the Sports Illustrated curse as well. I'm from Boston: Curt Schilling hopped on an F-150 in 2004 and put an end to my belief in curses.

Now, there can be an argument made that bull/bear sentiment indicators are contra indicators -- the thought being that by the time the sentiment reading is taken, bets have already been placed. We hear how the underlying economic recovery stinks. In fairness, recent data -- namely on jobs, retail sales, and consumer sentiment -- has shown a tepid recovery at best, as it has for the last few springs. We hear how the massive monetary stimulus wars that Japan, the US, and the EU are waging are simply helping prop up certain asset classes. We hear how social mood is terrible -- social mood is a huge driver of the market, and if it were not, 80% of MIT grads would be billionaires. Yes, we may in fact see a correction, but in my opinion the potential for a secular bull trend is still in effect.

Here's my humble take, for what it's worth:

1. Markets are geared to go higher, right? Two-thirds of Americans have some type of retirement vehicle, or another vested interest, in stocks. They want stocks to go up. This helps explain volatility as well: Stocks generally take the stairs up and the elevator down. According to a recent article in the Wall Street Journal, people are just starting to regain faith in the markets. We're seeing 5-year record equity/equity ETF inflows. Moreover, roughly 26% of American making $50,000 or less have little if any stock exposure. Remember, the individual investor has been stung by a plethora of punches: the tech crash, the housing crash, the mini crash, Knight's fat finger, and, more recently, the Facebook (NASDAQ:FB) IPO debacle and AP "Twittergate."

I work with Registered Investment Advisors (RIAs) and, from time to time, help them with strategy. As of late, they're not asking about duration on their bond portfolios and/or bonds that look attractive. Right now, they're asking about ways to find equity growth potential with income. What this rate environment has done is firm up corporate balance sheets in ways we have not seen in a long while, allowing corporations big and small to lock in cheap financing, and pay back shareholders through record buybacks and dividend increases. Capital structure is totally changing, making equities attractive for a long while to come from both a balance sheet and cash flow perspective. See Apple (NASDAQ:AAPL).

2. Investors big and small are really starting to embrace stocks on a larger scale, buying more equity exposure for income for the longer haul. We're not just talking utilities and select consumer staple names. For examples, see Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC) this past week, as investors are in the process of rotating out of consumer staples and into select IT hardware/software on a relative value/income/growth play: illustrating the former, the Consumer Staples Select Sector SPDR ETF (NYSEARCA:XLP) is up 19% YTD while, for the latter, the Technology SPDR ETF (NYSEARCA:XLK) is up 4% YTD.

Thematically, this is what is happening: Investors are selling high-yielding consumer staple stocks with perceived stretched valuations, such as Procter & Gamble (NYSE:PG), McDonald's (NYSE:MCD), and Johnson & Johnson (NYSE:JNJ), and buying old horses like Microsoft, Intel, and Apple in the tech space. That's right. Apple. As I said to a friend, who was inquiring as to why I was hanging around the night Apple reported last, "It seems our life revolves around a fruit."

So, Apple bulls say shipments were fine even in the face of poor guidance, margin compression, and lack of innovation (the bar was very low; so low that I would have to limbo under it). Moreover, the buyback / dividend fans got their wish: Apple doubled the buyback to $50 billion and increased the dividend by 15%, and will do this by issuing debt! Remember, Apple had a clean balance sheet -- welcome to America! Lever up! The bears say it's the end of the last American growth story; the last bastion of innovation. Now, it's a value/income play for an aggressive retirement portfolio.

Remember way back at the beginning of the year, the proclamations of a man who frankly, given relative size of portfolio, is simply one the best: Will Danoff of Fidelity's Contra Fund. He's a leading indicator for me, period. Here's what Mr. Danoff said late January:

What could 2013 hold for stocks? No one knows for sure, but I believe that well-managed companies toughened by the challenging conditions of recent years are generating record amounts of cash and their free cash flow (FCF) yields look attractive; particularly when compared to bonds, dividend paying stocks are going to be the theme du jour…This will be one of the only ways retiring folks can supplement dwindling fixed income returns in a world deplete of yield.

So, will income-oriented securities be the new core of retirement portfolios? Remember, these boomers have had more exposure to stocks throughout their life than in previous eras; some may argue too much. These people have been watching CNBC while eating their Corn Flakes. They are not trained to cut coupons and most do not have nearly enough to retire, as pensions continue to go the way of the wagon wheel. Additionally, many have avoided stocks, getting out at the nadir in 2008.

We know that since 2011, approximately 10,000 baby boomers retire every day, a fair number without pensions and / or adequate funds. Does one think an investment grade corporate bond paying 2.5% at the core of a portfolio is getting it done? No, I believe they will continue to try and catch up, as more faith is restored in the markets: They will take the Fed's bait and continue to embrace more risk.

Also, although we have seen some record outflows from fixed income products, i.e. the first week of April, from the junk bonds (NYSEARCA:JNK) and the IG corporate bonds (NYSEARCA:HYG), the rotation has not even begun yet in earnest. One has to presume that the average investor does not truly understand duration. In essence, if need be, it will bit a lot easier to sell a liquid high yield stock than to liquidate a bond portfolio, with prices underwater as rates rise.

Bonds will always have a place with a proper allocation, but I believe, a smaller allocation. We also know that when inflation does creep higher, historically it generally favors stocks under the premise that costs can be passed on to the consumer. Again, a bond portfolio laddered to buy the back end in in a rising-rate period can work fine, but I think, as a smaller percentage of the portfolio.

3. We hear the axiom all the time, "Don't fight the Fed!" It was one of the first things I heard at Morgan Stanley (NYSE:MS) when I was being sent home for sneezing on someone and / or grabbing coffees. Many are saying it's simply not working, that the Fed is not creating jobs or stimulating the economy, and even that there's now risk of deflation by government measures.... Really? Have you sat down and figured out your inflation rate? Moreover, last I checked, the Fed's main purpose is to increase the money supply, not address the fiscal side. We all know in this country that there's a lot of work to be done from a fiscal perspective.

So, let's just look at it from the perspective that the Fed is simply helping boost stocks. We have recently heard at least three Fed presidents, notably James Bullard, in light of recent data, suggest bond purchases could increase, not taper. We read the minutes that showed intentions of holding assets, namely mortgage-backed securities, to maturity, as opposed to selling. The Smartest Man in Global Capital Markets said that when the music (from the Fed) stops, there will be no chairs (buyers). Well, we may not need that many chairs if their holding the bulk of purchases to maturity, right? So, the landing could be softer, in theory.

But hey, we're not at that point. Not even close: This is the Brandenburg Concertos in whole. Thus, there's a lot of music left to be played in the context of reaching 2.5% CPI , or 6.5% unemployment. Can we shove the QE3 taper argument under the carpet for a bit, allowing stocks to move higher...a lot higher? We know how this has been working: Bad headlines are met with knee-jerk downside reactions. Then, the investor stimulus addiction kicks in and the high takes over, which just means more QE: "Buy, Mortimer!" The Fed may not increase purchases, but I think most of us can agree that the current purchases in place are not ending in the near future.

Just today after some early signs of panic-type buying in higher-beta energy and financial names, the equity markets, from my feedback, purportedly sold off on a couple macro headlines: First, Fed President Ben Bernanke at a Financial Stability Oversight Council meeting uttered that "vulnerabilities remain in the markets." Well, my reply was, will those comments just be construed as the continuation of QE and all its merriment? That the trend has been correct? And in trading, we tend to follow the adage "the trend is your friend." We all know Mr. Bernanke hates surprises.

Second, Bloomberg circulated a story citing that the Bundesbank had rejected outright monetary transactions, or European Central Bank buybacks, in an opinion to the top court. That would have the potential to put a trigger lock on the "pea shooter" that Mario "Ivan" Drago, I mean Draghi, has been wielding in the global stimulus war with Japan and the US. Let's face it: If investors in the US are "buzzed" from stimulus measures, then investors in Japan must have sake coming out of their pores.

4. To me (and I'm no expert!), social mood and recovery are most dependent on jobs and real estate. Last month saw a hideous payroll number as retail canned and / or stopped hiring. But, US job postings are near all-time highs. Sequestration effects are just starting to be felt, affecting places like IBM (NYSE:IBM) or contractors where there's presumably less money to go around. Some of the cuts are needed, and we're not talking about canceling White House tours in symbolic grandeur.

Seems to me that in the face of higher lending standards, the low rates inspired by the Fed have allowed a lot of bad inventory to move off the real estate market, i.e. spurring people to make foreclosure purchases, take a trip to Home Depot (NYSE:HD), and then flip the new house to a first-time buyer. As a baseline, housing is showing signs of being robust again. Prices are up nearly 8% year-over-year, and a whole cottage industry has been created around buying depressed property. It's simple: Working off the excess inventory allows neighborhoods to be cleaned up and new homes or existing homes to then come to the forefront. Now, many speculate that last week's figure of reported US existing home sales -- 4.9 million, or 85% of the market -- was light because of lack of inventory. However, in general, people are just starting to feel good again about housing. Moreover, when rates do in fact tick higher, that will, in my opinion, simply create a panic among those who have been reluctant to jump back in.

On the commercial real estate front, I posit that some analysts and / or talking heads (and maybe even Fed presidents) may be a bit offsides, except maybe Jim Cramer, who blurted out the other day: "I love REITs!" According to industry sources I have talked to, we're not yet at the top here, whether talking commercial mortgage-backed securities and/or REITs (and I mean select REITs, as this industry is typically "haves" and "have nots"): A good proxy for dummies like me is the iShares Dow Jones US Real Estate ETF (NYSEARCA:IYR), as it is diversified.

Here's what I believe: First, according to Pensions & Investments, north of 80% of public/private pensions are underfunded and are not meeting investment goals or return benchmarks. Again, they need more yield. Second, I already pointed out the baby boomer effect since 2011. The Smartest Man in Global Capital Markets pointed out in July that he felt most large institutions were offsides on equity allocations, and that has not changed overnight; and there's contention that recent outflows from High Yield and IG are finding their ways to REITs and CMBS.

Third, I recently talked with my brother-in-law James Francis McCaffrey Sr; some of you probably know him as "Jimmy Mac." Biases aside, after Jimmy Mac was cut by the Boston Celtics, and after a token Nestle Crunch commercial with Larry Bird (rated one of the worst of the 80s): he's gone on to a successful career in commercial real estate. He currently is one of the Senior Managing Partners of Eastdil Secured, the "ninja" commercial subsidiary of Wells Fargo & Co. (NYSE:WFC).

Jim has spent the last few years traversing the perilous EU and the UK, helping PMs / finance ministers / sovereigns and banks we read about every day raise Tier I capital by selling real estate holdings. Suffice to say, Eastdil is one of the preeminent players in the industry. Jim was succinct. I asked him first about demand. As we know, there's a lot of talk about "bubbles" in the segment. Even Fed president Eric Rosengren recently weighed in saying as much.

So, in the context of my aforementioned thoughts on chasing / seeking yield, I asked Jim his thoughts on whether demand for quality paper for CMBs/REITs is sustainable. Jim replied: "We'll see. Feels like there is a ton of liquidity for the foreseeable future for hard assets."

I then asked him where we are in the cycle with regards to peak pricing dating back to 2006. He replied, "We are back to peak pricing in gateway markets like NYC, DC, San Francisco, and as you get to the secondary and tertiary markets pricing is still 70 to 75% of peak." Jim is on the front line in terms of facilitating this paper. Commercial real estate, maybe ex-retail, may have a ways to go, as peak pricing can be sustained, in Jim's estimation, "as long as rates are low, and inflation is relatively in check." So again, we're back to the Fed, right? What's the time frame? Shinzo Abe and Bernanke are probably in what, round seven or eight out of a 12-round fight?

Conclusively, this is simply my view. I just think there's some different dynamics in place this time to sustain this rally longer term. I feel, as a whole, investors seem to be regaining some confidence in equity markets, and as such, there are still bets to be placed. Demographically, the baby boomer generation is in full effect, and some are chasing retirement funds, perhaps a bit more aggressively. This is what the Fed wants. The 5-year record inflows we have seen in equity and equity ETF products has been, by most estimations, comprised of cash from the banks and from investors stung by bad perception of stock markets past. Jobs and real estate may be just starting to turn in some depressed markets / segments: Could that continue to get people feeling good again?

New Home Sales checked in on Tuesday, April 23 at 417,000 versus the 416,000 survey number. The homebuilders have seen recent selling / shorting given YOY runs, and have responded this week up approximately 13% as a group thus far. Barclays also helped with an upgrade of the homebuilders. Housing is getting better. Depressed markets, i.e. Arizona, Nevada, and Florida are seeing double-digit increases in sales, in conjunction with price gains.

Technically, the equity markets still seem to be demonstrating a buy-the-dip mentality. We see this from the market's Teflon nature, shrugging of any bad news that seems to be thrown at it. This market does not yet want to break. On March 5, the Dow first set a record new high of 14,253.77; for all the "Dow Theorists" this was confirmed by a record close of 6136.72 on the Dow Transports Index (INDEXDJX:DJT).

Subsequent new highs with regards to the Dow Jones have not been confirmed by the transports, but, clearly, a buy-the-dip mentality remains in place. Yes, we may correct, and that in fact may prove healthy, but I humbly believe there are different dynamics in place to take stocks higher over the long term...a lot higher. It also does not mean we cannot take measures to protect our portfolios for the longer term. I, for instance, instead of outright selling, sold longer-dated upside calls against a portion of all of my equity exposure, and used the proceeds to buy some SPY (NYSEARCA:SPY) puts (essentially a collar). If I'm called away on a portion, +4% to +10% from here depending, so be it. Overwriting is a great strategy, notably in tax-deferred accounts such as IRAs. Buy the dip. At least, that's what I heard from a trader at one top-5 institution in the throes of a recent sell-off. I presume he was not alone in coming up with that opinion: He told me this right after his morning meeting.

Also see: Will It Be the Macro Market Week From Heaven or From....


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