It is tempting to conclude that the correction from the mid-January stock market highs has run its course, and a new leg higher in the primary uptrend from the March 2009 bottom has begun.
Certainly, there is persuasive evidence supporting this premise. The technical health of the market was threatened in the late January/early February sell-off, but has subsequently recovered in a convincing fashion. The long-awaited 10% stock market correction occurred amidst a typically unsettling news backdrop (e.g. the European debt crisis and a run of poor U.S. economic data), which quickly (and constructively) extinguished the investor optimism that prevailed at the start of the year. Selling pressure was intense for a short time, but could not be sustained, reflecting healthy underlying supply/demand conditions for stocks.
The major stock indices bottomed near their 200-day moving averages, have been moving steadily higher for the past three weeks, and have just exceeded their 50-day moving averages – all very characteristic of a routine correction in an ongoing bull market.
The NYSE Advance/Decline Line, a measure of market breadth, has just registered a new high (Exhibit 1), which is a very positive sign for the market, and suggests that the major averages will record new bull market highs in the weeks ahead.
Typically, breadth breaks down three to six months in advance of a peak in the broad indexes. According to Lowry Research, there have been only three instances (out of 18 bull markets) dating back to the 1940s where the NYSE Advance/Decline Line did not begin to weaken months before the formation of a major market top. The ability of the NYSE A/D Line to make a new high this week argues against the idea that a major top was made in January.
Apart from resilient technical action, the bullish case continues to derive support from extraordinarily loose monetary policy. Last month’s token increase in the “discount rate” was a non-event. Until the unemployment rate falls significantly (which is not imminent), the Fed has no intention of implementing true tightening. Ben Bernanke reaffirmed last week that short-term interest rates would be kept at their current (absurdly) low levels for "an extended period."
As a result, monetary policy is not likely to be an impediment to risk asset prices this year. Thanks to the Fed’s zero interest rate policy, the steepness of the yield curve (i.e. the spread between 10 year and 1 year yields) is as high as it has ever been (Exhibit 2), which should be bullish for financial markets since investors are forced out of cash into riskier assets and yields on the long-end of the Treasury yield curve are anchored to a degree by nonexistent yield at the short-end.
Government Response to Sovereign Debt Crisis
The bull market is not at this point threatened by extreme valuations or overly frothy investor sentiment, so for the time being, the path of least resistance is likely to remain to the upside. I continue to expect that 1200 to 1250 on the S&P 500 represents the upside potential for this bull cycle.
The greatest risks to the stock market appear to be (1) that the economic recovery fades, leading to major disappointments over corporate earnings, and (2) the growing sovereign debt crisis (Greece is only the beginning; government debt ratios are exploding in the vast majority of developed economies).
As far as the first point is concerned, it is clear that much of what lies behind the recovery in the markets and the economy is artificial, and that absent government stimulus, the economy would not be able to sustain its recovery without first completing the process of purging the excesses from the private sector debt bubble. The bursting of that bubble and the government’s response to it has no historical precedent (in the U.S., the closest analogue is the 1930s), so we should not use post-war cyclical experience to gauge how this recovery and bull market will unfold. We are engaged in an experiment with an unpredictable and potentially volatile outcome, which in and of itself argues for a healthy degree of risk aversion and a focus on wealth preservation.
The sovereign debt crisis is an extension of the unprecedented circumstances we are in. Due to demographics and unfunded entitlement programs, governments in most developed economies (e.g. the U.S., Europe, and Japan) faced a grim fiscal situation before the financial crisis. Now the outlook it downright frightening (Exhibit 3). More than one half of the U.S. government’s additional $9 trillion in debt expected over the next ten years is projected to be interest payments (Exhibit 4)!
No one knows when a crisis of confidence will erupt in the financial markets if we stay on the present path. The Greek experience seems to be a warning shot for the spreading sovereign debt crisis. The speed at which the marketplace reassessed Greek creditworthiness (Greece’s borrowing costs shot up three percentage points in a matter of weeks) should sound alarms for profligate governments around the world. If the U.S. and other similarly situated countries do not take action to begin to get their fiscal houses in order, markets will force reform by creating a financial crisis. Bond markets will eventually enforce fiscal discipline by demanding higher rates. The question, as always, is one of timing.
Our sense is that the sovereign debt issue is not going away anytime soon. It will likely recede for a period of time, but it will remain a major risk factor for the markets. The issue has received a tremendous amount of media attention in recent weeks, and investors are quite focused on the limits and consequences of government profligacy.
The market has absorbed $2.7 trillion of new Treasury debt over the past two years, yet the 10-year Treasury yield was virtually unchanged over that period. The government plans to issue a comparable amount of new debt over the next two years. I seriously doubt that markets will continue to be able to absorb the glut of new Treasury bonds without higher rates.
Bond bulls argue that an increase in longer-term Treasury yields would be self-limiting because the economy (and the real estate market in particular) cannot handle significantly higher interest rates. In other words, a potential rise in the Tnote yield to 4.25% or 4.5% from 3.6% currently would precipitate another economic slump, which would in turn be supportive of bond prices.
The counter-point to this is that a contracting economy would impair government tax receipts and likely engender a continuation of “stimulus” programs, causing government deficits and debt to remain on their long-term rising trend.
Given the deflationary forces in the economy and the anchor of zero percent short-term interest rates, the 10-year Treasury yield may fluctuate between 3.5% and 4.0% for the next several months (Exhibit 5), but looking out over the next 1-2 years, it is hard to imagine that 10-year Treasury yields won’t rise above 5% in light of the fiscal and monetary policies that are currently in place.
The U.S. dollar has been in a clear uptrend since early December (Exhibit 6). The dollar has benefited from a Greece-induced flight from the Euro, which has dropped 10% (from 1.51 to 1.36) over the past three months. Prior to this move, the dollar was excessively undervalued versus the Euro (and other “major” currencies such as the Yen and the Pound), which have the same fiscal and monetary problems as the U.S. as well as additional problems such as a lack of political union (Euro) and a shrinking population (Yen). Some prominent hedge funds are betting that the Euro will fall an additional 30% to achieve exchange-rate parity versus the dollar. That seems to be a stretch, but a retest of the late 2008/early 2009 Euro lows in the 1.25 range seems quite possible, and any short term rebound in the Euro should be capped at 1.40.
Given that the course of U.S. policy-making remains dollar bearish, we expect that dollar weakness will manifest itself against emerging markets currencies and gold, rather than against the Euro and other similarly challenged major currencies.
Investors seeking exposure to a diverse basket of emerging markets currencies have an attractive option in the WisdomTree Dreyfus Emerging Currency ETF (CEW). The fund is equally weighted in 11 of the most liquid emerging markets currencies. The fund is reasonably priced at 0.55%, and trades with bid/ask spreads in the range of 0.05% to 0.15%. CEW has attracted $390 million of assets since its launch in May 2009.
In light of sovereign debt risks, zero or near zero interest rate policies, and a lack of credibility among the major currencies, suffice it to say that the financial environment remains friendly to gold. The notion that gold was simply an anti-U.S. dollar trade has been discredited by market action thus far in 2010. The U.S. dollar index is up 2.5% year to date, and is up 5% versus the Euro. Meanwhile, gold is up 3.5%. As a result of the European sovereign debt crisis, and instability within the European Union, the Euro is no longer seen as an attractive alternative to the US dollar. Gold is increasingly seen as an attractive alternative to all paper currencies (not just the dollar), and has just made a new high in Euro terms.
The technical action in the gold market has been bullish (Exhibit 7). Gold held support well above $1000, and has recently broken to the upside of a downward sloping channel that had been in place from the early December high. Driven by demand from both private investors and emerging market central banks seeking diversification of their reserves, gold should rise to $1500 at a minimum over the next two to three years with downside risk limited to $1000.