The chart below shows this relationship more graphically.  The charted line is the earnings yield of stocks (the S&P500 index in this case) less the yield on 10-year government bonds.  Given the inherently more risky nature of stocks, we would expect the earnings yield on stocks to be somewhat higher than government bonds, but the chart shows that this difference has steadily expanded over the past decade and remains near record levels of almost 6 full percentage points! 
dec12-1

So stocks are historically cheap compared to bonds; that alone won’t lead to a shift in assets back to stocks.  We have seen these anomalies go on for years before.  The catalyst might be a shift in view about interest rates.  A continued recovery in global growth and worries about inflation could start the movement out of bonds that has dominated fund flows over the last five years.  Will 2013 be the year we really begin to see money move out of fixed income and into asset classes like equities?  Will large investment pools finally take action to reduce their exposure to an asset that is likely to return less than the rate of inflation for the foreseeable future?  Since hitting a recession-driven low in March 2009, the Dow Jones Industrial Average has doubled in value. But many ordinary investors remain too fearful to join in the gains.  After two stock collapses in one decade—2000-2002 and 2007-2009—along with scandals, the rise of high-frequency trading and worries over Washington’s ability to rein in debt, investors are skeptical about stocks.  Individual investors yanked a net $900 billion from U.S. equity funds since January 2000, according to fund flow tracker EPFR Global. Stocks and stock mutual funds now make up 37.9% of the average U.S. household’s financial assets, down from 50.5% during the height of the tech-stock boom in 2000, according to the U.S. Federal Reserve.

Much of this negative sentiment towards stocks is shown in the chart below, courtesy of BAML.  Their ‘sell-side indicator’ measures the sentiment towards stocks by tracking the views of strategists, economists and sell-side analysts to get a ‘net sentiment indicator’ for the stock market.  Given that most of those indicators tend to be ‘contrarian’, extremely bullish readings tend to be negative, or bearish, for stocks.  The indicators are currently at their most bearish levels on record, suggesting that it is an extremely good time to be adding stock market exposure.
Bearish Investors = Bullish Stocks

History continues to show how it has been a profitable strategy to bet ‘against the crowd’ when the consensus becomes this extreme.  The reference earlier to the performance of the Irish, Portuguese and Greek stock markets in 2012 (the so-called “PIIGS’) is just another indicator of how investments can go the opposite direction to what the crowds expect, particularly when the rhetoric gets so extended.

With the fiscal cliff pushed off for now, crisis fears in Europe abating and global growth improving, one of the important themes of 2013 is likely to be inflation.  A big uptick in inflation would be a significant headwind for equities in 2013 but we are not seeing any of the typical signs of imminent inflationary pressures. As the global economy picks up steam, inflation will likely follow, but at this point, we expect that to be more of a 2014 issue than one in the coming year.  Despite the trillions of Dollars, Euros and Yen being printed by the respective central banks, forward looking measures of inflation indicate that there is little risk of a meaningful increase in inflation, at least through the first half of 2013.  We expect the debate over inflation to be one of the dominate topics next year as investors turn their focus from fears of the Euro imploding toward fears of excessive monetary and fiscal accommodation.

But the central banks may be starting to worry about inflation a bit more.  The U.S. Federal Reserve is eyeing the end of four years of extraordinary economic stimulus, with near unanimity from officials that the costs of intervening to drive down borrowing rates are starting to overtake the benefits.  Quantitative easing (QE), or creating money to buy financial assets, could end “well before the end of 2013” because of concerns by several policy makers over financial stability, and that the Fed’s portfolio of assets – now over $2-trillion (U.S.) – is becoming too large, according to minutes of the central bank’s December policy meeting, released in Washington this week.  The Fed’s commitment to QE currently is open-ended, causing some market participants to characterize the Fed as on cruise control – at a speed in excess of posted limits. The minutes alter that impression, describing instead a central bank that is growing wary of its real-life experiments in monetary policy.  The possibility of the end of quantitative easing comes even as the U.S. government begins to withdraw fiscal stimulus, with payroll, income and other taxes on the rise.

The biggest risk to financial markets if the central banks start to ‘take away the punch bowl’ in terms of low interest rates is the run-up in commodity prices, particularly gold, that we have seen over the past five years.  Some of those fears have been pushing gold prices lower lately. The yellow metal took a real pounding last week, making it six weeks in a row on the downside, the longest losing streak since May 2004.  Hedge funds have been dumping it hand over fist, and speculative holders as a group have sliced their positions by nearly 50%, even while central banks have been adding to theirs.  India, which has been a ferocious buyer of bullion, is ready to slap a bigger tax on gold imports.  The combination of fast money exiting and negative readings of the charts by market technicians has sent the metal spiraling downward and fanned fears that the decades of massive appreciation are coming to an end and the great bull market in bullion has seen its final days.  Yet the devotees of bullion remain steadfastly bullish.  Bloomberg surveyed some 49 traders and analysts, and found that the majority were still banking on gold as a hedge against inflation and a safe harbor for depreciating paper currencies, neither of which has helped gold recently.  Maybe the best thing that could happen to the precious metal would be a kind of reverse gold rush — a thorough shakeout that would send fidgety owners to the sidelines.  In other words, a bout of bearishness might be what is needed and would clear the ground for a bullion revival.

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