There is still some upside left in the XLF as we head into 2018, yet I think there is greater risk i...
What's ahead for the next twelve months in stocks
07/01/2011 8:30 am EST
This stock market, in my opinion, shows a short-term July rally inside a summer slump, inside an emerging markets rally, inside a liquidity-fueled boom, inside a liquidity-fueled bust.
That’s why right now when any one asks me “What do you think of the stock market?” my first question is “Over what period?”
Let me start with the innermost doll and work outward.
Welcome to the (relatively short-lived) summer rally. From 1950 through 2010, according to the Stock Trader’s Almanac, July has been the sixth best month for stocks (measured by the Standard & Poor’s 500 stock index. June, in contrast, has been the third worst month.
This year the market tanked to a very over-sold condition in June, setting up a July rally. All investors have been waiting for, as stocks got cheaper and cheaper, was a break in the consistently negative news flow of May and June.
Well, we’re sure getting that break in the negative news flow. Greece and the European Union look like they’ll succeed in their efforts to kick the Greek and euro debt crisis down the road. The European Central Bank has just about guaranteed that it will raise interest rates on July 7—producing a euro rally against the dollar that will do wonders for commodity prices. (See my post on the Trichet rally http://jubakpicks.com/2011/06/29/euro-interest-rates-to-climb-in-july-and-stocks-should-follow-along/ ) China’s Premier Wen Jiabao has declared victory against inflation (http://jubakpicks.com/2011/06/24/china-conquers-inflation-premier-wen-says-so-and-what-does-that-mean/ ).
It’s important to remember that in the short-run it doesn’t matter whether or not any of this news is actually true. All that counts is that investors, temporarily, will themselves to believe.
And if you can judge from the technical charts, and I think you can, they believe. Yes, they do.
In the last few days, U.S. stock indexes have rallied from support at their 200-day moving average, offering evidence that last week marked a short-term bottom, and that the indexes are ready to move back to resistance at their April highs. This is true for the Dow Jones Industrials, the S&P 500 and the Nasdaq Composite.
Sectors, such as energy and materials, that had led the sell off in May and June, are bouncing off their 200-day moving averages too in anticipation of a weaker dollar.
Overseas markets show the same pattern. The iShares MSCI EAFE index (EFA) has recovered to its 200-day moving average. (This index is weighted 66% to European stocks and 20% to Japan, so it should rally strongly with an appreciating euro.) The iShares MSCI Emerging Markets index has bounced so strongly off the 200-day moving average that it is now threatening to move above its 50-day moving average.
Don’t get too excited by this July rally. We had one last year too and it pooped out in August. From a low of 1023 on July 2 the S&P 500 climbed 10.2% to a peak on August 4. 10% in a month sure ain’t bad. But then the market decided to give most of that back with the S&P 500 falling to a low of 1047—a drop of 7.1% from its August 4 high.
That’s pretty typical for a summer rally—short and sweet—and for August too. If June is the third worst month from 1950 to 2010, August isn’t much better—it’s the fourth worst month.
And I think there’s good reason to believe that August could be disappointing again. Much of the July rally, if that’s what’s coming, is based on cheap valuations. Not just in the United States, where the S&P 500 was trading at less than 13 times projected 2011 earnings before this week, but also in emerging markets such as Brazil. At the June bottom Brazil’s Bovespa index traded at just 9.9 times projected 2011 earnings.
That makes the July rally kind of self-limiting since every increase in stock prices means that stocks are just a little less cheap. And with the U.S. economy sputtering along in a weak recovery, it wouldn’t take much in the way of a return of risk to end the summer rally. The most likely candidate is the battle in Washington over raising the U.S. debt ceiling.
It’s very much a no-winner situation. If Congress doesn’t raise the debt ceiling, the U.S faces at least a temporary technical default in August. That wouldn’t be good for the dollar or U.S. interest rates or the U.S. economy.
If Congress strikes a deal that follows recent pattern, Democrats will cave to Republican demands for short-term budget cuts. What we need is long-term serious debt reduction—no deal is likely to include that and so financial markets will be disappointed. Economists will rightly point out that cutting spending in the short-term when the recovery is so weak will endanger the economy. That will increase worries about growth.
Back to the summer slump. Which, if 2011 is like most years, will continue into September, historically the worst month of the year for stocks.
But now let’s move out a level to a slightly larger doll—or a slightly longer time horizon. If you look past the summer slump, I think you can see the shape of a stock market rally like the one that began 2011 and reached to a peak in April. Only this one will be fueled by emerging and European markets. The U.S. market, which led the rally in the first half of the year, is likely to lag.
And it all comes down to interest rates—or at least it mostly comes down to interest rates.
By the second half of the year global financial markets will be anticipating the end of a cycle of interest rate increases in most of the world’s emerging markets. (Possible exception India.) Remove the downward pressure that rising interest rates and the threat of slowing economic growth impose and these markets—remember they’re historically cheap after falling from November 2010 highs—are ready for a sustained bounce.
Especially because the most recent solution to the most recent Greek crisis will have removed some worries about taking on risk. Nobody really believes that a second rescue package for Greece will be any more effective at solving the long-term problems of the euro than the first one was, but the effort will be enough to enable investors to forget their fears that the euro was headed for a meltdown. Besides, an interest rate hike or two from the European Central Bank will have pushed euro benchmark rates up near 2% by the end of the year, making the common currency a very attractive currency.
The United States, meanwhile, is likely to experience the worst of two worlds. The Federal Reserve will remain sidelined by fears of slow growth in the U.S. economy. That will weaken the dollar against the euro (and help push global commodity prices higher.) But the Federal Reserve only directly controls short-term interest rates. Long-term rates will edge higher as overseas investors demand higher yields in order to offset a sinking dollar. Higher interest rates will, in turn, slow the U.S. economy even more, making sure that the Fed stays on the sidelines even longer and that overseas investors have to be bribed with even higher yields to buy U.S. Treasuries.
That takes me to next doll or 2012. I expect this to be a wild year as the politicians from Washington to Moscow to Beijing vie to buy approval (if not always actual votes.) We’ve got a presidential election in Russia—think Vladimir Putin won’t do everything he can to make sure that voters are happy? We’ve got a leadership transition in China—think Xi Jinping and the other new leaders jockeying for power as Wen Jiabao steps down won’t do everything they can to make sure that China’s economy doesn’t falter?
And we’re got a presidential election in the United States. This is a huge wildcard. Yes, the incumbent will do everything he can to make sure that unemployment falls and growth speeds up, although it’s not exactly clear what Barack Obama will be able to do with Republicans in control of the House of Representatives. But Republicans have a vested interest in seeing the economy continue to struggle. At the least they’ll be tempted to block anything that might give the President an economic success to talk about in his campaign.
I think what this adds up to for 2012 is another round of easy money and lose credit. Economies that haven’t completely cooled down from the fast growth induced by the post-global economic crisis stimulus will get new gasoline poured on the embers. A stumbling U.S. economy might be enough to keep some pressure on the brake but I’m not counting on it. I think we’re in for another liquidity boomlet in 2012.
Which brings me to the last doll, the babushka—also known as 2013. Booms—and even boomlets—don’t end well. We should know that by now. Especially when the bills for so many problems come due all at once. The Greek rescue package is designed to get Greece to 2013 or 2014. The U.S. presidential election will be over—and all the budget deficit problems that no one dealt with in 2011 or 2012 will be that much tougher to fix—but that much more necessary to fix too. China’s leaders will be again fighting the inflation that they claimed they had vanquished in 2011.
And what really worries me is that governments and central banks, having spent much of their ammunition on the global financial crisis in 2008 and 2009—and not having produced the economic growth necessary to refill their weapons—will have less, much less, to throw at any crisis that emerges in 2013.
This all seems very neat and orderly now. It won’t be, of course. We’ll have plenty of scares along the way—food riots strike me as a real possibility given the historically low levels of global grain reserves and global weather patterns are likely to get even more crazy due to climate change. We could even get a shocking dose of good news from a technology breakthrough—my pick is an innovation that sends the cost of producing solar energy plunging—to an outbreak of political courage and creative thought about addressing global problems of aging and lagging job growth (yeah, who am I kidding).
The one thing that is easiest to imagine upsetting all these dolls—so much so that they all roll for the hills as fast as they can—is a U.S. budget crisis. A credit rating downgrade. A political miscalculation or two or three about exactly how fragile the U.S. economy is. Another hit to house prices from rising interest rates. The number of ways that I can imagine to create a crisis in the United States is truly frightening.
We have lots and lots of easy ways to get ourselves into very deep trouble.
Any babushka could tell you the same thing: Getting in trouble is easy, she’d scold. Staying out of trouble is harder but still very easy. Getting out of trouble, once you’re in it, however, is really, really difficult.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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