MorningWord 9/2/14: Wake Me Up When September Ends

by Dan September 2, 2014 9:29 am • Commentary

Last month’s towering accomplishment in the S&P 500 of finally topping the nice round number of 2000 was the surest way to get some equity market strategists dreaming of 3000.  This morning, Morgan Stanley’s strategist laid out a vision for a 50% gain by 2020 (which could be the peak in the current bull run) in a note to clients, which was succinctly summarized by Business Insider’s Sam Ro:

 Our best guess is that an S&P 500 peak of near 3000 is possible should the U.S. expansion prove to have five or more years left to it, based on 6% per annum EPS growth through that time frame and a 17x price-to-earnings ratio,” Parker writes.

Here’s their bulleted summary (verbatim):

-The world economy is not in sync. Major regional economies are at different points along the growth cycle. In general, DM is leading while EM is lagging.

-Volatility in the U.S. continues to trend lower, which can extend the life of expansions.

-Deleveraging in the U.S. is ongoing, albeit largely complete, and balance sheet priorities have shifted.

-Interest payments on debt burdens are ultra-low, and household debt dynamics suggest there exists a sizable cushion protecting consumers in a rising interest rate environment.

-Capital spending and inventories do not look stretched.

-Corporate management hubris and other corporate metrics of overheating remain muted.

-Several broad economic indicators in the U.S. have only just reached “normal” expansionary levels and are far from looking unsustainable.

All valid points, and most of the conditions cited above have been in place for the last few years.  I am not a strategist, and while I have a good sense for history, I also recognize that there are few examples in the recent past where economic conditions have much resembled the ones that we are in now.  We are in uncharted territory, especially on policy.  

While it makes perfect sense that the S&P 500 should be considerably higher than it is now in 5 years, there is also a decent likelihood that the index will have a considerable correction or two or three at any points between now and then.  5 years is a long time.  5 years ago, in 2009, the end of the world still seemed a distinct possibility. I guess the main point here is that Parker lays out a very logical framework for higher equity prices through the end of the decade, but let’s not forget where we came from (S&P 500 up 200% since the March 2009 lows), and giving credit where credit is do, with risk asset prices having benefited from unprecedented monetary stimulus.

Will the mounting geopolitical concerns in the Middle East and Europe have the potential to curtail the global economic recovery?  I suspect that for those who used August’s price action in most major equity markets for a guidance on the potential severity of geopolitics (S&P 500 closed at all time highs up 3.5%, the Euro Stoxx 50 closed at 1 month highs up 1.8%, and the VIX closed down 30% from the July 31st highs), it would be easy to dismiss as a non-event.  But summer trading is summer trading, and given the high levels of complacency (we are in the longest period since the mid 1990s without a 10% correction) I suspect the recent low volume, low volatility leg of the rally could have had more to do with low liquidity and a lack of large sellers rather than a signal about the risks to the broader market from developments abroad.

One last note – implied volatility has been a bit better bid in the past week relative to the very quiet price action in the underlying SPX index (10 day realized volatility has fallen to 4).  VIX spot has remained above the June and July lows (and the front-month VIX future has as well):

VIX spot, daily chart
VIX spot, daily chart, courtesy of Bloomberg

Traders likely expect a pick up in movement in the coming weeks.  That doesn’t necessarily have to be lower – some are speculating on a potential buying climax in the coming weeks or months after the new all-time high.  That type of price action could also mean higher volatility, though a sharp move lower in September would probably be a bigger reason for a move higher in the VIX.