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Pamela Rosenau Headshot

Winter of Content?

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Although we are in the middle of winter, I am already seeing signs of the first thaw... in equity markets that is. I believe that we are headed for a melt-up in the US stock market through 2011. The 'Winter of Discontent' in England in 1978-79 was characterized by widespread strikes over the government's attempt to curb inflation via pay freezes. Today the US is experiencing the opposite inflation scenario. Fed Chairman Bernanke is charging full steam ahead with quantitative easing policies because of the belief that inflation is "below optimal levels." Could this lead to the 'Winter of Content' for US equity investors?

A loose monetary policy environment is always a good backdrop for a rally in equities. But even though we have already seen major moves up, I think there is more to come. The market has been very fickle over the last year, which has led to under-performance by professional managers across the board. About 75% of managers underperformed their benchmarks in 2010, with close to 90% of core managers under-performing. Even some of the top dogs have been struggling, with the Wall Street Journal pointing out that there are more than a dozen mutual funds that have been in the top 20% of their Morningstar category over the last 5-10 years that were in the bottom 10% of peers for 2010. This means that a lot of people are going to be chasing alpha this year.

Considering how under-invested the typical retail or high net worth individual is, I think there is the potential for the market to extend 2010's rally in 2011. In 1999 and 2000, investors poured over $400bn into domestic equity mutual funds. In contrast, in 2009 and 2010, we saw over $100bn of domestic equity outflows. How exactly does that translate into an overbought market today? Data from Swiss private banks has confirmed that investors are still sitting on record high cash levels. Even if the typical investor is showing up late to the equity party, isn't it likely that they are going to bring enough booze (ie investable cash) to keep things going for another while?

There are some attractive fundamentals in the US to support a continued move higher. The S&P is trading at 15x earnings vs a historic average multiple of around 16.4x. People say that a low growth environment is not conducive to multiple expansion. However, GDP growth and stock returns are typically not correlated. Equity performance depends more on earnings growth, which is a function of margins and the cost of/return on capital. In the current low inflation/high unemployment environment employees have lost their negotiating power, so corporates will benefit from stable labor costs. (Incidentally, this is not the case in emerging markets where the combination of rising inflation and labor shortages means costs are likely to be on the rise, making investing in those markets less attractive than investing domestically).

One sector that looks poised to generate earnings upside and impressive market returns is energy. While people seem to be underweight domestic equities in general, this is even more apparent in energy. The short interest (number of people who are betting on prices going down) is at a one-year-high. The sector currently comprises about 12% of the total S&P market cap, whereas it has reached almost 30% at its peak. At the same time, fundamentals look positive. We are seeing signs of increasing demand for energy, evidenced by the oil market recently moving into "backwardation" -- where current oil contracts are priced higher than future ones. This means that current demand is outstripping current supply to such an extent that people are willing to pay a premium to secure the oil now.

Take note of this structure, because I think it could translate into the equity market as a whole. As money comes off the sidelines, people are going to start paying up for exposure.

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