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US Stock Market Rally Sustainable

(January 27, 2012)

Dear Subscribers and Readers,

While the Fed did not implement a QE3 policy this week, it is clear that the doves remain in charge—with the Fed promising to not hike rates until 2014; and with a further promise to implement QE3 should the US economy slows down (assuming inflation remains subdued) later this year. In addition—as we have previously discussed—central banks around the world are easing in droves, including inflation-prone India, which just lowered its cash reserve requirement ratio. Make no mistake: Central banks are not running out of bullets, especially with the recent collapse in short-term Spanish and Italian sovereign yields.

Another for our benign view (at least in the US stock market) is the ongoing decline in leverage within the US stock market, as exemplified by the amount of margin debt outstanding (which we last addressed in our December 29, 2011 commentary “All Quiet—For Now”).  Since the February 2009 bottom, total margin debt outstanding has risen by 51%, and has retraced about 47% of its peak-to-trough decline from July 2007 to February 2009. However, subscribers should note that margin debt outstanding has declined by 16% since its May 2011 peak.  Over the last six months (till month-end December 2011), margin debt outstanding declined by $43.7 billion to $301.6 billion:

Margin debt likely rose this month as the market powered higher. However, investors are still risk-averse, and there is still significant room for margin debt to grow before the market starts to become vulnerable to a significant correction. As such, the US stock market likely bottomed in late September/early October, especially given the hugely oversold conditions in our sentiment indicators at that time. Bottom line: The recent decline in margin debt outstanding is a reflection of a general aversion to risk-taking and deleveraging; and is thus indicative of a benign financial environment at least for the next couple of months.

Meanwhile, another U.S. stock market liquidity indicator—the amount of cash sitting on the sidelines—has recently declined but still has further room to move. This is measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background.  Since its February 2009 peak, it has declined very quickly, but has bounced slightly over the last nine months.  As of the close yesterday, it is about 1.6% above its cyclical bull market low (set at the end of April 2011), as shown in the following chart:

As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has declined consistently from February 2009 to April 2011.  The ratio bottomed at 28.00% at the end of April 2011, and has since bounced to 30.61%.  This liquidity reading remains low, however, and along with the possibility of more “Black Swan” risks, this suggests market conditions may change for the worse in the latter part of this year. For now, this indicator suggests the current market rally has more room to run.

The $64 trillion question is: How far can this rally go? Let's look from a valuation perspective. The fine folks at Morningstar have done much to “democratize” stock research to retail investors—with widespread coverage on both U.S. large and small caps—as well as disclosing assumptions behind their DCF models. For those interested in the aggregated valuation of the stock market, Morningstar has compiled an average valuation of its entire coverage universe of over 2,000 U.S. stocks. I track this on a regular basis. Today, this indicator is at a relatively oversold level of 0.94 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”):

Assuming 2012 corporate earnings growth isn't revised downwards (yet again), a rather conservative estimate is a rise to Fair Value (which was where the late June 2011 rally ended), In other words, Morningstar's proprietary valuation indicator suggests that the market may rise another 6% before enduring another correction—putting the Dow Industrials firmly in >13,000 territory.

Signing off,

Henry To, CFA, CAIA

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