Quite frankly, with the admittedly little training and experience that I have had so far, I don’t understand the market that we have with us. To me, it does not make sense when we have a bull market in both equities and fixed income, and when the rally in equities since 1,350 in S&P in Oct 2012 has been led by defensive sectors such as Healthcare, Staples, Telcos and Utilities, which is usually not the case. So, this is clearly not about economic fundamentals. I took a Ph.D. class at Cornell on microstructure where the professors talked about two different theoretical models of how prices move—information (when investors learn something new about the company or the economy) and inventory (when they buy/sell because they need to maintain a certain level of inventory of securities). Of course, it is always a mix of the two, but I think currently the market is more about inventory and less about information, because the player with largest inventory in the market is an active participant pushing everyone else along the risk curve, despite what market probably would otherwise do given just the information.
The trick that the companies have pulled off is the way that they have, on aggregate, managed the operating margins very well. You can see that the small caps’ margins, who you’d think are the suppliers to the bigger companies, have stayed flattish at about 6% since the beginning of the recovery, whereas the large caps’ margins have recovered from 10% to about 13.5%. Tax rate for the companies is also multi-decade historic lows.
All in all, I am not sure when it will change, but I think something has to give in the equity markets. If I had to speculate, equity markets will return a negative return compared to long-dated Treasury benchmark, and most likely against the HY benchmark as well.