Markets have come roaring back lately, fueled by optimism that the Fed is in no hurry to start scaling back its stimulus measures any time soon. The S&P 500 benchmark index has nearly pierced the 1800 mark, and the Dow is closing in on an all-time high of 16,000.
This upbeat investor sentiment is based, in part, on comments made by Janet Yellen, the White House nominee to replace Ben Bernanke as Fed chair in January, who struck a dovish tone recently before a Senate banking committee.
Ms. Yellen gave no clear hint on when the Fed might begin “tapering” its monthly asset purchases, but she did say it was “imperative to do what we can to promote a strong economic recovery.” She also played down the existence of asset price bubbles that might threaten financial stability.
Traders took this as proof positive that the Fed will stay on the sidelines a while longer, and that the powerful elixir of stimulus money would continue to fuel markets higher.
But while markets cheered the comments by Janet Yellen, others have been warning that things have gone too far, too fast.
Former Morgan Stanley economist Dr. Andy Xie has been warning about the dire consequences of asset bubbles for most of his career, but now he is really sounding the alarm.
According to Dr. Xie, the global flow of hot money into government bonds and real estate has reached such a scale that the current asset bubble is greater than the one that unleashed the 2008 financial crisis.
In his latest missive, Dr. Xie suggests that the Fed’s attempts to stimulate U.S. employment has only led to job growth by competitive devaluation, with Americans and Europeans cutting their pay to save their jobs. Worse, he reckons that the inflationary effect of money printing has been exported to emerging markets, where real estate has been on fire.
In China, rental property yields are now as low as those experienced in Japan at the peak of its real estate bubble. Rising property values in China and other emerging markets has created a dangerous feedback loop where hot money is flowing back into Manhattan and London.
There is ample anecdotal evidence of Dr. Xie’s theory, such as London property developers who, when faced with soaring property values, are not even bothering to market new riverside apartment blocks in Britain. Instead, they are marketing these properties directly to investors in Hong Kong or Singapore.
The Chinese Society for Economic Reform recently estimated that the amount of “grey” or unreported income of China’s rising bourgeoisie has topped US$1 trillion – and this tsunami of cash is currently looking for safe refuge in Europe and North America.
To the doomsayers, the end of the bubble will occur when emerging market inflation is exported in ever-greater quantities to the United States, a situation that will force the Fed to act by imposing higher real interest rates.
Money from emerging market economies is already flooding the real estate market in the world’s money-center cities. Given enough of a rise in real estate prices and other asset prices, the Fed may have no choice but to act to curb inflation.
Over the summer, we had just a taste of the potential for damage when the Fed hinted that it would taper its quantitative easing and emerging markets entered into a nasty tailspin.
Money from emerging market economies is already flooding the real estate market
The impact of tumbling emerging markets sent currencies spiraling downward. Hot money fled, finding temporary shelter in North American and European stocks and bonds.
With the Fed flip-flop in September, fast money flows have once again reversed and the bubbles have resumed their expansion.
Any slowdown in China’s ability to provide low-cost goods to the developed world could result in inflationary pressures in goods and services. This, in turn, would force bond yields sharply higher in North America, cratering the global bubble economy once and for all.
Toronto is experiencing a real estate bubble in its own right, with the greatest number of condo completions in the history of the city scheduled for 2014.
Some Toronto real estate brokers are targeting clients in Russia, the Middle East as well as Asia, and many of the new developments are being sold sight unseen. Could a top in Toronto real estate prices be far away?
A possible party spoiler for the Toronto and Vancouver condo markets, however, could be a prolonged downturn in the emerging markets.
If Western central banks start to withdraw stimulus or, worse yet, begin to tighten, emerging markets would get hit hard. Foreign investors faced with tumbling stock prices at home could be forced to liquidate their Canadian and U.S. real estate portfolios in a desperate attempt to stay afloat, putting downward pressure on a real estate market that has risen too far, too fast.
Central banks in the West have been content so far to let asset prices surge as employment gains remain tepid and their economies remain weak.
Surging property markets in Manhattan and London is not a principal preoccupation of the Fed. And unless broader-based inflationary pressures assert their impact on the American economy, the Fed is unlikely to drop their accommodative stance.
There is little doubt in our minds that there is an inflationary bubble building in some major world cities that is being fueled in large part by offshore money. Any substantial move higher in the cost of money would send real estate prices tumbling.
While equity prices have moved higher on the back of central bank stimulus, the multiple for the markets remains slightly below the long-term averages, suggesting a bubble has not yet formed in equities.
While such a bubble is a distinct possibility, there is scant evidence of any problems developing so far. Indeed, global economic conditions have been improving for the last four months, suggesting better days ahead for stock investors.
Leveraged to growth
With most economists forecasting global growth in 2014 heading for a four-year high of four per cent, investors should be thinking about sectors that are levered to global growth.
Technology screens the best in terms of growth rates, balance sheet strength and valuation of any Global Industry Classification Standard* (GICS) sector.
Best yet, technology tends to lag a pick-up in the economy by two to three quarters, suggesting that there is still ample time to buy some of your favorite tech names.
Tech stocks to consider
One such name that we really like is Amazon.com (NASDAQ-AMZN, $366.86). The company already accounts for nearly 20 per cent of U.S. online retail sales, but the company’s strong mobile positioning, coupled with next- and same-day delivery options, will allow it to take share from its major online competitors.
The company also has the best, most consistent management team on the Internet. Margins are set to rebound to the 2003-2010 average of six per cent, further supporting the company’s stock price.
* Our Advice: a buy rating on Amazon.com and a 12-month target price of $425 per share.
Google Inc. (NASDAQ-GOOG, $1,031.46), the leading internet search company, is another name that we like.
Google, which has been ahead of the pack in search and search advertising for some time now, accounts for more than 70 per cent of global search ad revenue.
Given its very strong position in mobile and ongoing innovation, the company should be able to continue expanding its share for the foreseeable future.
The big driver for revenue growth is a shift from traditional advertising to Internet and mobile advertising. In 2012, U.S. internet advertising revenues were $37 billion; global Internet advertising spend is approximately $75 billion, but growing at close to 20 per cent annually.
* Our Advice: a buy rating on this stock and a 12-month price target of $1,125 per share.
Netflix (NASDAQ-NFLX, $342.62) is another company poised for strong appreciation in the months ahead. Netflix is an Internet subscription service for watching TV shows and movies. Subscribers can instantly watch unlimited TV shows and movies streamed over the Internet to their TV’s, computers and mobile devices.
The company has 31 million U.S. subscribers and eight million international subscribers, which makes Netflix one of the largest global entertainment subscription businesses.
We believe that their impressive customer base and sustainable level of scale, growth and profitability is not yet reflected in its stock price.
* Our Advice: a buy recommendation on the stock and a 12-month price target of $440 per share.
The Bottom Line
While the bears have been coming out of hibernation after each successive market high, stocks in North America do not look excessively valued.
The cries will only get louder as global growth resumes and stocks that are linked to a rebound in world growth begin to participate in the rebound.
This is one of the few times in recent history when Europe, North America and China are all working at the same time.
Markets are poised to move higher as fixed income investors, who’ve enjoyed thirty five years of rising valuations, finally decide that stocks, not bonds are where it’s at.