(This guest post originally appeared at the author’s blog)
Bubbly Ben has engineered one of the most incredible liquidity driven rallies in the history of the stock market. The reflation trade, made famous by John Paulson, has been a huge winner for investors prescient enough to engage in it. The reflation trade has been primarily due to the prodding of monetary policy. After all, they don’t call it a “stock prod” for nothing. Ben Bernanke is literally herding investors into risk assets as they watch their cash produce less than lackluster returns at 0%. Investors remain over-allocated in cash and the obvious winner of this cattle prod market is equities (regardless of the fundamentals).
Some big banks including JP Morgan are paring back their recovery chatter as signs of slowing begin to surface:
History and data suggest that the recovery trade has played itself out, for the moment. Indeed, during the last two recoveries from US recessions, it was at this point that economists started getting disappointed by the data and began lowering growth forecasts. And the history of the last six US recoveries shows that equities rally reliably during the last three months of a recession and the first three to four months of recovery. But, then, the path is wide open, and anything is possible.
Add in the approaching end of an almost miraculously good year and investors can be forgiven for taking money off the table. We did some of that last month, but we do not see a good reason to go short on risky assets. This is because our economists give us no hint that they will lower
their growth projections and the second factor we have been relying on, asset reflation, remains in full force.
Nonetheless, they continue to think risk assets will outperform as investors are forced to reach for risk:
As we argued last week, moving toward a period of less excitement on economies and markets reduces uncertainty and volatility, and thus induces a continued flight from the asset class that feeds off risk––cash. We have called this the asset reflation trade and remain solidly attached to it. It shares with the recovery trade a taste for equities and credit, but in contrast, it is bullish bonds and bearish commodities (as the latter pay no income).
The recovery trade has been a great friend for seven months, but has lost power. We move it to neutral and rely instead on the flight from cash, the asset reflation trade, which is long all positive yielding assets.
It seems counter-intuitive, but despite the weak fundamentals of the underlying economy, the liquidity outlook continues to favour the risk trade. Bubbly Ben is engineering the greatest reflationary environment in the history of markets. I think most investors know the Fed can’t print us back to prosperity, but that doesn’t mean Bubbly Ben’s rally can’t last much longer. As Keynes famously said, markets can remain irrational longer than you can remain solvent.