The panic into quality

Two weeks ago, I gave a presentation entitled 'How to Distinguish Between a Bear Market and a Bull Market Correction'. What I said in that presentation was that, in the long term, the Federal Reserve will continue to increase rates. The Fed has told us itself that it will increase rates between now and 2020 from 2.25% to 3.5%. That 3.5% Fed funds rate is incredibly likely to provoke a major sell-off in bonds. On average, US Ten-year bonds trade 200 basis points higher than the Fed funds rate and that means a US long term bond rate of 5.5%. It's difficult to see how that wouldn't create a bear market in US stocks and also Australian stocks.

This is not that bear market, this is a bull market correction. The reason we know this is not a bear market is that we have two tests. Firstly, the US economy is growing too strong. The US announced a growth rate for the 3rd quarter of 3.5%. That growth rate was 1.5% percent higher than the average growth rate of the US economy. So, the US economy is far too strong and profit growth is far too good.

The other thing we look at is US corporate credit spreads (the availability of liquidity coming into the US equity market). You only get bear markets in the US when those spreads are well above long term average. Right now, they are well below long term average. There is too much money supporting US equities.

So, growth is too strong, earnings are too strong and there's too much liquidity into the US equities market for there to be a bear market in progress. What we've got here is a bull market correction.

The character of this bull market correction is very similar to what we experienced earlier in the year. The market got ahead of itself in terms of the amount of liquidity coming into the market. So, it's correcting down to a level which is appropriate for liquidity. As in the beginning of the year, this had generated a very rapid sell off in a short space of time. With 22% of US earnings reported and today's bond yield, we calculate fair value of the US equities market, the S&P500, at 2882 points. That's 176 points higher than where the market finished trading on 25^th October.

Now that means that the US market is 177 points too cheap relative to fair value and that's the cheapest the US market has been since August 2013. So quite remarkably this sell-off has restored genuine value to the US equities market.

When we look at the Australian market, we think fair value is at 6060 points. That means that on 25^th October we were at 380 points too cheap. We were exactly in this same position at the end of March this year after that correction. After that correction, we generated a very strong period of upward markets and higher levels. I think that's what we'll experience between now and April next year.

It is interesting that at the same time that we've had this sell off in stocks, we've had a general flight to quality. As stocks have been sold, investors have moved to bonds. We've seen bond yields go down both in the US and Australia. We have also seen a flight to the US dollar. The US dollar has gone to a new short time high relative to the Euro and the US dollar index has gone to new short-term highs. Those short-term highs appear to be putting in something like a double-top in comparison to where the US dollar was about two or three months ago.

Particularly after the US elections, we think that there will be some major institutions staying out of the market to find out what the result of those US elections are. After the US midterm elections, we think there will be a confidence in the US of investing abroad again. We will see that the Euro will start to go up and the US dollar index will start to go down. After that we will begin to see the recovery not only in currency but also in US and Australian equities