Take a step back from the day-to-day headlines, and you’ll have to agree…
…global financial markets have been on a roll…
The U.S stock market has soared 15% from its lows in early June. Almost three-quarters of the shares in the S&P 500 are above their 200-day moving average. That figure is even higher in some international markets. Meanwhile, the VIX — the “fear index” — is as low as it has been since the subprime crisis began. If you followed the time-tested investment advice to “sell in May and go away,” you missed out on some big gains.
With earnings season in the United States kicking off today and markets now comfortably into the fourth quarter, traditionally the strongest quarter of the year, the outlook for the rest of the year looks solid. According to sentimentrader.com, going back to 1950, the S&P 500 has gained during fourth-quarter earnings season 66% of the time, returning an average of 2.1%.
And there is still plenty of cash on the sidelines to push the market up. Despite U.S. 10-year Treasuries yielding just 1.7%, the global rally in stocks has not been driven by a stampede out of bonds. In fact, mutual funds investing in the U.S. markets continue to see outflows of $500 billion a month as frustrated U.S. retail investors continue to abandon the stock market in droves.
Why the Worry?
Despite the markets’ recent strong performance, there are plenty of reasons for cautious investors to worry.
Bullish data on the performance of U.S. markets during Q3 earnings season notwithstanding, October has a well-earned reputation as the worst month for investors. U.S. shares have fallen by more than 10% more often in October than any other month. Never discount the possibility of an “October surprise.”
Then there is a flashing red light from the venerable Dow Theory. If the economy is improving, the Dow Jones Industrial Average and the Dow Transportation Index should rise together. When the Dow Transportation Index declines, diverging from its better-known Industrial big brother — as it has recently — the broader market often follows suit. That’s worth paying attention to. Over the past century, the Dow Theory has proven to be remarkably consistent, beating the broader Dow Jones Industrial Average and S&P 500 by 1%-2% each year.
Yet, in this world of “risk-on” and “risk off,” investors remain cautious primarily because of general uncertainties about the future of the world economy.
Let’s start with Europe.
Despite the European Central Bank’s (ECB) commitment to buy the sovereign debt of its fiscally strapped members, Europe remains in economic doldrums. Yes, the ECB’s bond buying strategy has avoided the break-up of the euro. But it has not stopped Europe’s current recession from deepening. Socialist governments in France chasing businessmen out of France with a 75% tax rate are hardly encouraging, except to real estate agents in my neighborhood in London, where business from French expatriates fleeing Paris is booming. Meanwhile, Greece is entering its sixth year of recession — making its economic contraction longer than the Great Depression in the United States.
Then there is the looming “fiscal cliff” in the United States — the automatic U.S. tax rises and spending cuts due in January that may lop off as much 5% from the U.S. gross domestic product (GDP). European investors now view this is a greater danger than the break-up of the euro. Conventional wisdom says that the U.S. Congress will pull back in this fiscal game of chicken at the last minute. Maybe. But nothing will happen until after the presidential election in November.
Finally, there are the growth prospects of the global economy.
The International Monetary Fund (IMF) has been ratcheting down steadily its estimates of global growth for 2013. The IMF now estimates that global economic output will expand by 3.6% in 2013, down from its July estimate of 3.9%. And that assumes the United States pulls back from the fiscal cliff.
The IMF’s estimate may turn out to be overly generous for one big reason. It is still in denial about the size of the looming economic collapse of China. Educated in Keynesian departments of economics, IMF economists have yet to grasp the long-term implications the biggest centrally directed mal-investment in economic history. As certain as the outcome is, it’s still unclear whether the collapse will play out benignly, as in the case of Japan, or as an outright political revolution like what you saw in the Soviet Union. That potential “Black Swan” event doesn’t make it into IMF calculations.
Markets Climbing the Wall of Worry
Strong market rallies such as the one we’ve seen since June are inevitable, followed by substantial corrections. That’s just market dynamics. Yet long-term falls in the market almost always come after excessive optimism. And that hardly describes the current global state of mind. One of my favorite measures of investment sentiment is the American Association of Individual Investors’ sentiment survey, which shows bears and bulls evenly split across the board.
The bottom line?
I think an increasing possibility of a Romney victory in the U.S. elections, combined with a traditionally strong Q4 rally, will trump potentially disappointing U.S. earnings over the next few weeks. That’s why I’ve been selling down defensive positions in my discretionary managed accounts, positioning them for greater gains between now and the end of the year.
Markets are climbing a wall of worry. And I think they will continue to do so in the months ahead.
