Jurrien Timmer: As Good as It Gets

Jurrien Timmer: As Good as It Gets




The clearest case against calling investor sentiment “excessive” is to simply look at fund flows. After all, investors vote with their wallets. The fact is, since the February 2016 low, U.S. equity funds and ETFs have taken in a net total of only $11 billion,4 which is peanuts compared with the U.S. stock market’s $28 trillion market cap.

While it’s true that ETFs took in a sizable $299 billion, active funds had outflows of $287 billion. Globally, the picture shows more investor optimism, with flows into global equity funds and ETFs (including the U.S.) totaling $188 billion. But even that’s a drop in the bucket compared with a global equity market cap of $44 trillion.

One can also look at various surveys of investor sentiment. For the week ending October 11, the American Association of Individual Investors (AAII) Investor Sentiment Survey shows 39.8% bulls (its historical average is 38.3%) versus 26.9% bears.5 That’s hardly excessive. Elsewhere, the bullish sentiment for both MarketVane and Consensus, Inc., are at 71%, which show moderate optimism but nothing extreme.6 So does all this represent a frothy and overly optimistic sentiment? Is this a bubble? I highly doubt it.

What could derail this market?

Other than a sudden exogenous shock (geopolitical or otherwise), which are notoriously difficult to quantify, here are the main risks as I see them.

A hard landing in China resulting from tighter policy in response to the massive credit impulse in early 2016 could cause the global earnings picture to sour. This in turn could put pressure on equity valuations and, therefore, stock prices.

If the Fed (and other central banks) tighten interest rates more than the markets are currently pricing in, that could also put downward pressure on valuations. This would likely only happen if inflation forces the Fed’s hand, but so far core inflation remains well below the central bank’s 2% target.

But if it did happen, it could lead to a rise in the term premium,7 which since 2009 has remained well-below its normal range (currently, the term premium on the 10-year Treasury is negative). A more-normal term premium (100 to 150 bps) would mean a higher risk-free rate,8 and that would affect the valuation of all financial assets, including stocks. In my view, the below-normal term premium (suppressed by global QE) has been the transmission mechanism that’s driven the valuation of all markets higher.

What to watch/brace for

I am closely watching China as a proxy for the global earnings cycle and the Fed as the catalyst for the bond market. I think the Chinese economy is going to be okay over the intermediate term, so that really puts the Fed on my radar as an important factor for the coming months.

A December rate hike is now very much in the cards (markets are pricing in a 77% probability). Taken by itself, that’s no big deal. However, as I’ve highlighted in recent commentaries, there remains a disconnect between what the market is pricing in for the next two years (2.5 hikes) and what the Fed is implying via its dot plot (7 hikes).

This disconnect is illustrated in Exhibit 1. Currently, the Fed’s policy rate (the interest rate banks charge each other for overnight loans) is 1.25%. The fed funds curve, which reflects the markets’ expectation for the future direction and pace of Fed hikes, reveals a modestly higher trend. However, the Fed’s long-term dot—its longer-term federal funds forecast—is decidedly higher than what the market expects.

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