WHICH market is going to crack first - bonds or equities? This question has been hotly debated in the US for three years now and neither market is willing to back down.
The time is fast approaching when we find out who is right and it will have ramifications for investors around the globe including Australians.
The Dow Jones Industrial Average sits just 10 per cent off its all-time high and is poised to make a run at a new record that will spell the end of the secular bear market.
Ignoring a relentless torrent of dire economic news to climb a wall of worry, the world's dominant equity market has powered 106 per cent higher over the past 3½ years. In contrast the US bond market has factored in another decade of low to no economic growth, with 10-year bond yields at just 1.5 per cent, well below the levels touched immediately following the global financial crisis.
The world's largest bond trader Bill Gross from PIMCO blurted out his thoughts last week, saying the "equity culture" that has hypnotised Americans for the past century was drawing to a close.
He cannot see how the sharemarket can continue to deliver real growth (after inflation is taken into account) of 6.6 per cent in the future. Oddly, most people nodded in agreement despite the massive returns US equity investors have notched up over the past three or so years.
Bond market participants are generally viewed as the smartest guys on the block.
As a collective they are more savvy than their sharemarket counterparts at predicting economic trends. Gross and his colleagues are so bearish they are saying US interest rates will only move 25 basis points higher over the next three years, suggesting the world's largest economy is heading down the same deflationary path as Japan.
Deflation is viewed as a cancer among economists and its long-term impact on asset prices is there in plain view for everyone to examine via the Japanese sharemarket.
These grim economic predictions have been latched onto by a clutch of commentators such as Nouriel Roubini, Harry Dent and John Mauldin, who as equity bears have become household names.
What if the bond market and its band of merry supporters happen to be wrong?
What if the supposedly naive sharemarket players that are punting on a bright future are right? Given the tumultuous events since the tech bubble burst in March 2000, no one has really thought about this, including me. If the bond market does crack and its 30-year bull market ends an ocean of money will come flooding out of fixed interest into other assets.
The prime candidate to benefit from this would be equities. This would see the US and other markets around the globe surge higher at a rapid clip. If this scenario was to play out in the coming months, Gross' "death of equities" comment would symbolise the bottom for equities.
So why are we going to find out who is right and who is wrong in the coming six months?
The answer to this sits with the sharemarket. Since the beginning of the new millennium the US sharemarket has risen to about the current level several times. On each occasion it hasn't liked the view and headed in the opposite direction in double-quick time. History tells us that once a market makes a clean break through the previous record high, it rarely looks back.
Given the US market tends to perform best from October through to May, the Dow Jones Index, if it holds together over the next few months, could have a genuine crack at bursting into uncharted territory. We are at a critical time.
The broad S&P 500 Index is trading on a relatively mild price-to-earnings ratio of 13 times 2012 earnings and, if the analysts are proven correct, just shy of 12 times 2013 earnings.
This is far from historically expensive but for earnings to grow at double digits, the current economic growth rate of below 2 per cent will not suffice. After five years of cost cutting, revenues must start to pick up to drive earnings. If earnings could grow 30 per cent over the next three years and the PE multiple expanded to the average of 15 times, the S&P 500 Index would be trading at about 2000 points - about 50 per cent higher than now.
I would love to be a contrarian, but I share the bond market pessimistic outlook. In previous secular bear markets the US economy has experienced between four and six recessions over two decades.
The sharemarket has responded by dropping the average market PE ratio down to about eight times. On 2012 earnings this would see the S&P 500 drop 35 per cent to about 900 points. Like everyone else I am about to find out who is correct.
What does this mean for Australia?
A bull or bear market in the US will have a major influence on the direction of the local sharemarket. With the average PE multiple of just 11 times and the dangers of the resources bubble largely behind us, the Australian market is well positioned to base and move higher if the bond kings of the northern hemisphere happened to be wrong like we all are occasionally.