Newsletter | March 2012

How Do You Like Me Now?

February marked the Dow’s 5th straight month of gains.  That this was preceded by 5 consecutive monthly losses causes one to consider continued symmetry.  While the stock market has an unquestionable cyclical nature, it’s not normally this obvious.  Nevertheless, with the calendar soon reading “May” (as in ‘sell in May and go away’), combined with the change in investor sentiment and other concerns, this rally could be getting long in the tooth. 

As one would expect, the markets are much different after climbing 20% from the October’s lows.  Aside from higher prices, the shift in investor sentiment from last summer’s despair to today’s optimism is remarkable.  Rewind to 2011’s third quarter and we find anxiety over Europe with attention to a possible Greek default.  Of course, the markets had a list of domestic problems to fret over as well.  QE2 had just ended and there was doubt surrounding the economy’s strength. 

Chiefly helped by rising stock prices, these worries have moved to the backburner.  With regards to Europe, it’s unclear whether recent developments are an actual solution or whether Wall Street is just fatigued over the situation.  Regardless, investors have turned optimistic toward the economy and the stock market.  A recent NAAIM Money Manager Survey showed that 73% of respondents were bullish.  Last September’s bullish readings were less that 20%.  Even long standing, high profile bears such as Nouriel Roubini and David Rosenberg turned bullish. 

This type of widespread capitulation usually takes place closer to the end of a trend rather than the beginning.  The historic length of this rally is noteworthy and would suggest a forthcoming pause.  Last Tuesday was the first 1% or greater daily drop for the S&P 500 in 2012.  Dating back to 1928, this 44 trading day stretch is the seventh longest to begin the year.  Furthermore, the S&P has had its ninth best yearly start and it’s the best start ever for the Nasdaq Composite. 

Trees don’t grow to the sky and neither do stocks without a correction – eventually.  That many are waiting for a correction may delay its ultimate arrival.  Or rather, given society’s quickened pace, it’s possible that last Tuesday’s one day ~1.5% drop was it.  This pullback was broad based and had many preparing for more downside.  The major indexes recovered these losses on Wednesday and Thursday which negated the damage.  For all of the week’s commotion, the markets were little changed. 

    Last Week  2012
Dow Jones Industrial Average    -0.43%    +5.8%
S&P 500   +0.09%   +9.0%
Nasdaq Composite   +0.41% +14.7%
Russell 2000 +1.82% +10.3%

Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends.

Apart from the short term, 2012’s strong start is a bullish sign for the year.  The S&P 500 finished higher in 7 out of the past 10 best yearly beginnings.  And there is clear fundamental support for this view as such things as the employment situation, housing, and consumer confidence continues to improve.

The More Things Change, The More They Stay The Same

Ironically, it’s the similarities of March 2012 and September 2011 that cause the greatest worry.  Despite last week’s Greek default (the same default that was supposed to crumple the capital markets late last summer), we think the European sovereign debt and banking crisis remains as big a risk as it did last year.  The countries with the most debt are the least competitive.  Add to this a cultural structure which won’t be easily improved and we think the problems are far from being solved. 

A second dangerous similarity between these periods is the same flawed monetary policy.  Abnormally low interest rates and abnormally high money printing is the mantra of every central bank and this does not appear to be ending soon.  In fact both Brazil and India lowered interest rates last week. It’s noteworthy that two of the fast growing BRIC countries (Brazil, Russia, India, and China) are trying to stimulate their economies.  Back on our shores, the latest pronouncement from the Federal Reserve is to keep short term interest rates low through 2014. 

If interest rates are considered a cost of money, our central bank is clearly manipulating that price which presents the risk of unintended consequences.  We understand the logic behind the current stimulative policy - de-leveraging banks, falling monetary velocity, and a slower than normal economic recovery to name a few.  Still there are consequences to this mispricing of the use of money. 

The real interest rate is defined as the quoted rate less inflation.  Thanks to the Fed’s diligent work, it is currently negative.  While the goal of ZIRP (zero interest rate policy) is to encourage consumption and business investment, the risk is that it ultimately results in poor decisions.  As a recent example, the housing bubble’s genesis can be traced back to Alan Greenspan’s choice of loose monetary policy.  The Maestro lowered rates and printed money (sound familiar?) as a way to combat the bursting of the tech stock bubble.  To be sure, there are many other components to the sub prime lending mess, but we think it’s not just coincidence that the early 2000’s was a period of negative real interest rates. 

Perhaps Chairman Bernanke won’t repeat the mistakes of his predecessor and there are many who have confidence in his ability to know the right moment to remove the punchbowl.  Of course there is just as many who doubt his skills. 

Just as there is no assurance of an eventual financial calamity, there is no guarantee of avoiding one.  But the outcome of the global central banks’ decision to throw money at the obstacles facing the financial system certainly adds risk to the landscape.  This risk should be a focus going forward. 

When it comes to the stock market, the possibility of material capital misallocation isn’t an immediate concern.  Investors are properly watching a growing economy and strong corporate balance sheets.  Additionally, 2012’s strong start typically has bullish implications for the rest of the year.  And last week’s recovery after Tuesday’s plunge speaks to this point. 

With the end of the first quarter quickly forthcoming, any correction could be postponed.  That’s not to suggest risk has been outlawed, but only to offer that it’s not as obvious as it was last year.  2011’s markets were overshadowed by obstacles facing the worldwide economy.  Conversely, 2012’s attention is centered more on economic growth and its positive impact on stock markets.