Bet on This Rally (...Cautiously)

09/18/2012 9:15 am EST


Jim Jubak

Founder and Editor,

More aid from central banks and the potential for more good news should keep this rally going through December. But there's enough risk to keep MoneyShow's Jim Jubak, also of Jubak's Picks, from going all in.


If you're trying to figure out where stocks are headed from here—and who with money in the US stock market isn't?—you have to start with that number, the Friday, September 14 close for the S&P 500.

The number won't tell you where stocks will be in a week or a month or by the end of the year. But it does tell you how to think about the odds of the market moving higher from here or falling back. Here's why 1,465.77 is important.

On June 1, the S&P 500 closed at 1,278.04, the low for the year. If the index was near that level now, I would be willing to bet dollars to doughnuts that US stocks would keep climbing.

On the other hand, even though the index is at highs not seen since the end of 2007, a correction isn't a lock. US stocks have built up considerable momentum. Thanks to a falling dollar (thanks to the Federal Reserve's announcement of a new round of quantitative easing), commodities have broken a downward trend that goes back to May 2011.

The S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite have all broken above resistance on rising volume. The rising volume part of this is important—it says that investors are buying more stocks, even as prices rise. That's good news for any rally.

To simplify the situation radically in the short term, the course of the US market will be determined by what investors and traders decide is the best way to make money for the rest of 2012.

Gentlemen, Place Your Bets
Some traders and investors will decide that going short on a bet that US stocks will fall from current high levels is the best move.

For a lot of traders—and hedge-fund managers—that would be a continuation of a bet that hasn't paid off terribly well this year. You could say these traders are doubling down on that strategy, hoping that it will pay off in the remainder of 2012.

And some traders will decide to ride the momentum. If they're behind the indexes, they'll be tempted to go riskier in an effort to make up ground by buying stocks with higher betas—greater risk, with a chance for greater return—than the market as a whole.

And if they're ahead or even with the indexes, they'll decide to keep on doing what has worked so well over the past few months and buy stocks that bet on the US housing recovery, that will rise along with commodity prices if the dollar continues to fall, or that will profit if the fall and holiday retail season turns out to be as strong as is now projected.

The winning strategy for the rest of 2012 will depend on which of these two alternatives attracts more money. And that, in turn, will depend on traders' reading of indicators and events over the next few weeks.

In December, I'll bet we'll see lots of gurus intimating that the winning trend was inevitable or certain earlier in the quarter. But that simply won't be true. The current market can turn either way—which makes it a tricky and risky market. And the way it turns will depend on a news flow that can't be predicted right now.

I think that the news flow over the next few weeks will seem positive enough to reinforce the market's current upward momentum. But that doesn't make the continuation of the rally a sure thing.

At the moment, it looks as if the best chance of making money lies in going with the momentum. But I wouldn't pile on the risk in the US part of my portfolio. Long US stocks, yes. Aggressively long US stocks, no.

Walk on the Mild Side
Here's why I come out on that side of the US market.

  • Growth in the US stands a good chance of coming in above very low expectations.

In the past week or so, better-than-expected numbers on inventory levels, retail sales, auto sales, and home sales have led to very modest increases in growth projections from Wall Street economists.

Granted, the projections are extremely modest—expectations that growth in the third quarter would match the 1.7% annualized growth in the second quarter have yielded to projections of 1.8%, 1.9%, or maybe even 2%. But Wall Street is perfectly capable of talking itself into a belief, especially after the Fed's announcement of QE3, that the economy's growth rate is picking up significantly.

  • Despite all the long-term, unsolved problems that still beset the Eurozone, the news flow there is likely to remain dominated by stories about falling bond yields in Italy and Spain, and progress toward getting the Eurozone's permanent bailout fund, the European Stability Mechanism, into operation in the coming weeks.

Eurozone leaders are about to deliver something that they're really good at—a series of summits—in October and November. That should keep the idea of progress toward a solution alive.

  • A stronger euro on that belief in Eurozone progress means a weaker dollar, which means higher commodity prices.

And higher commodity prices will push up commodity stocks, which will give US markets the upward leadership from oil, base metals (iron ore and copper), and gold that they need.

  • It looks as if Brazil and China, the big two among developing economies, could finish the year strong.

In Brazil, the government has cut its growth forecast for 2012, while at the same time projecting higher growth in the third and fourth quarters. (That seeming contradiction is actually a reflection of extremely weak growth in the first two quarters that has lowered likely growth for the year but left room for a second-half performance that outshines the first half.)

In China, government economists have just reported that growth would pick up in the third and fourth quarters from the 7.6% growth rate in the second quarter. That would push China's growth rate for 2012 to 7.7% to 7.8%, above the government's goal of 7.5% growth.

Again, those numbers aren't especially strong—for China—but they would represent a clear bottom in China's growth above the level that many economists had feared. In other words, no hard landing for China.

If the market receives news like this, it's enough—when added to the stimulus from the Federal Reserve and the stabilization package announced by the European Central Bank—to keep this rally going into December.

Not a Lock
Of course, the news could be significantly more negative than this. And enough negative views could convince the market that the shorts and bears are right, and produce a downturn in coming months rather than an extension of the rally.

What could go wrong?

  • We could see a renewed crisis in Greece, because that government has so far been unable to persuade the inspectors from the troika—the International Monetary Fund, the European Commission, and the European Central Bank—to authorize the next payment in the Greek bailout package. The Greek government says it can squeak by until November, but a major part of the money was earmarked to prop up Greek banks. A loss of confidence in the Greek banking system (or let's say a further loss of confidence) could send this all out of control.
  • Right now, the markets seem to be assuming that after the US election, all the parties will sit down and work out a way to avoid sending the US off the fiscal cliff in January, when automatic budget cuts and the expiration of the Bush tax cuts could threaten to stall the economy. Politicians? Rational discussions? A compromise solution? How likely is that? If the elections in November embolden or weaken one party significantly, someone may start grandstanding in a way and on a schedule that freaks the market out.
  • Spain could wind up in chaos if the government of Mariano Rajoy keeps refusing to request a bond-buying program and the regional governments rise up and refuse to cut their debts.
  • The October transition to a new set of leaders in Beijing could produce enough publicly visible infighting to rattle the Chinese—and thus global—financial markets.

Color Me Cautiously Optimistic
I've probably missed a few pluses and minuses, but you get the thrust of my argument, I hope: The odds favor a continuation of this rally, but not overwhelmingly so. You certainly want to give your portfolio a chance to participate in any upside, but I don't think this is the time to pile on risk in the US markets.

Dividend-paying stocks in general, and in the energy field in particular, look attractive. Sectors that would appreciate with a good retail season (trucking, for example) but that haven't appreciated wildly look attractive. Sectors that might be able to score gains even if the general economy doesn't turn in better-than-expected growth—such as housing—deserve a dollar or two.

A last reason to be cautious on US stocks is the very real possibility that Chinese and other emerging-market stocks could wind up outperforming US stocks if the global economy breaks as positively in the remainder of 2012, as it could.

Chinese stocks are cheaper than US stocks right now and are nowhere near a high. If traders go for the risk-on trade in the next few months because the US economy looks stronger and the Eurozone looks more stable, Chinese stocks might reap a bigger benefit than their US counterparts.

Please note that nothing in this column or in these scenarios imagines that the market will rise on fundamentals. The best that I can say is that the rest of 2012 will look better than current low expectations. I'm talking sentiment and cash flows not growth of earnings and gross domestic product.

And nothing in my scenario suggests that the global economy won't have to pay the piper sometime down the road. We've witnessed a huge expansion of global credit and global money supply as central banks have struggled with the Great Recession.

The global financial system still faces the challenge of coping with the reversal of those balance sheets and the turmoil that will come with a need to continue a deleveraging that hasn't progressed very far outside the United States.

At some point, kicking the can down the road just won't be an option.

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 June see the fund’s portfolio here.
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