The scene: midnight in a small Midwestern town.
It’s a slumber party. Pigtailed, middle-aged, fund mangers are sprawled over sofas watching films.
Painting their toe nails, eating frozen yogurt, and giggling in their PJs about dreamy Brad from the high school football team – things are just peachy.
Sandy, a long-short equity fund manager and the Most Popular Girl in School, heads for the kitchen to get some more soda.
But Sandy takes a while to return. Puzzled, Jenny – who manages a $1bn EM fund – goes to check on her.
A blood curdling scream rips through the house: the opening credits for THE TIGHTENING come rolling down the screen.
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The most oft repeated argument for why the current rally is built on sand is that money cannot remain loose forever.
Yes, liquidity-drunk investors may be partying now, but they will suffer for this over indulgence when ultra-loose monetary policy is reversed.
Mass panic will ensue in the markets. Squealing fund managers will be crushed like so many fat men simultaneously piling through a revolving hotel door, and cackling bears will revel in their own rightness.
Analysts, clearly smelling the fear, have begun to look backwards for previous market reactions to sudden and sustained rate hikes. They need tips on how to survive THE TIGHTENING.
So, do you keep skin in the game, or run screaming for the hills?
Teun Draaisma and Morgan Stanley’s European strategy team have the following advice:
Is it worth trying to capture the upcoming last ~10% of a ~70% rally? We feel we are in the latter stages of this cyclical bull market, before the period of indigestion that typically occurs when the tightening phase starts. We recommend investors use significant further market strength to position for the next phase. In the aftermath of secular bear markets these tightening phases could last for four quarters, while markets fall by 25%; 2004 was a benign version of such a tightening period, and even then it lasted for two or three quarters while markets fell 8%. Our best guess is that this tightening period will start before summer 2010. We keep in mind what Jonathan Bell Lovelace, founder of Capital, is quoted as saying: “When everyone wants to sell, you accommodate them and buy. When everyone wants to buy, you accommodate them and sell. Don’t try to get the last 5 percent. Don’t be greedy”.
JP Morgan’s European equity strategy team, on the other hand, certainly don’t foresee any prolonged hiccup and recommend buying into any weakness after interest rates are hiked:
Equities tended to peak 3-4 months ahead of the first hike, flattening into it. Equities fell every single time over the next 3-4 months following the start of hikes. The range of equity falls was between 6% and 15%.
• Importantly, we highlight that the turn in monetary policy was historically not a game changer, ultimately the equity uptrend resumed. The start of tightening produces a dip which should be bought into.
• Sectorwise, Cyclicals tended to lag following the first hike. Financials performance was muted ahead of the hike, but stronger thereafter. Energy performed well ahead of the start of rate normalisation, but would weaken subsequently.
• Clearly, the assessment of the potential impact of the start of policy normalisation is complicated currently as there are a number of nonconventional measures in action, ranging from the emergency liquidity programmes to the asset purchases. It is reasonable to expect the liquidity provision programmes to roll-off as funding markets have stabilized. With respect to reversal of asset purchases vs. the rate hikes, it is likely that interest rate normalisation proceeds ahead of any start of asset disposals.
Better get ready.
Related links:
Where to find value in a liquidity drunk market – FT Alphaville
The US stock market is overvalued by 40% – FT Alphaville