Another look at US equities

Macro Man has found relatively little to interest him over the past month or two, which explains the relative paucity of contributions in this space.  To be sure, the abject performance of the US economy in Q1 was notable, but as of yet the uneven bounce-back has rendered him unable to either confirm or deny that the weakness was primarily weather-related.  Europe, meanwhile, remains stuck in the same danse macabre with Greece that has featured regularly for the last several years.   Zzzzzz.  China, of course, appears to be following a Fed-like prescription of keeping the economic balls in the air by encouraging a financial asset bubble rally.  While that's clearly interesting and could ultimately represent the endgame for China's deceleration towards more "normal" levels of economic growth, we may have a ways to go yet before that plays out.

In the absence of inspiration, it is often useful to default to first principles, which in Macro Man's case includes some of the quantitative work he's done in  equities over the years.  Even there, however, the signals are far from unambiguous.  His bread-and-butter regression model, which combines five factors to generate a 12-month return forecast, has been remarkably stable at a remarkably bullish level:

However, this chart illustrates the limits of a regression framework as much as it does the supportive case for equities.  A linear regression is, by definition, linear, thereby assuming a constant proportional change in output for each change in the inputs.   In normal circumstances, this is perfectly fine.   When there are outliers and extremes, however, things can get quite messy when working with factors that are in reality asymptotic rather than truly linear.   Such is the case with this model, where the extremely low readings of headline CPI have perhaps exerted an "overly bullish" influence on the output.

To be sure, when dis-aggregating the model's output into "growth" and "liquidity" dynamics, we can see that the former has actually been quite bearish while the latter has been close to an all-time high.   As this model sees it, low oil prices have provided more financial market accommodation than QE ever did!

Of course, as we know CPI is subject to base effects- and oil prices have already rebounded smartly from their lows of a few months ago, which markets can react to in real time.   The model, however, must wait until the base effect phases out over the next eight months.  By the same token, the growth factor may also have been impacted by oil prices, in this case negatively via energy firms' lower earnings and capex.  That having been said, the tepid contribution from the growth dynamic predates the collapse in oil and could prove worrisome once the liquidity dynamic (as influenced by either oil or Janet Yellen) recedes.

These distortions in the linear model are one of the reasons that Macro Man also combines the factors into a scorecard, with each of the five inputs receiving a score of +1 or -1, depending on whether it exceeds a given threshold.  As noted previously, at the turn of the year the scorecard down-shifted from a max positive reading to a +3, where it has remained ever since.

To be clear, a +3 is still generally conducive to equity gains, but not nearly as much as a +5.  Indeed, when Macro Man runs risk using this model is only 0.5 of a base unit, as opposed to 1.5 units when the scorecard delivers its strongest endorsement.  Macro Man finds it telling and worthy of caution that the scorecard has affirmed its more cautiously bullish stance after years of rampant bullishness in the QE era.

So how are we left?   If one believes that markets are linear and that liquidity trumps all (call it the 'Funny Money' model), then by all means, buy with both hands, particularly on dips.  A more pragmatic (and, dare your author opine, realistic) viewpoint is that while the wheels haven't fallen off, neither is the equity market trucking along with the same momentum (both price and fundamental) that has characterized the last several years.

Much like the case for the US economic rebound, Macro Man at this juncture can neither confirm nor deny that "sell in May" will be a wise call in 2015.  What he does know, however, that any legitimate rebound in economic activity will be met with renewed speculation of Fed tightening, which could push growth and liquidity drivers of equities in ways not observed for a number of years.  It therefore behooves him to continue to assess these factors from a number of different perspectives as he attempts to tease out the trajectory of equities and other asset markets.