Dealing With Artificially Positive Stock Market Conditions

 |  Includes: DIA, QQQ, SPY
by: J.D. Steinhilber

It is the season of prognostications in the investments profession, but I will refrain from hazarding any guesses about how 2011 will turn out. As we enter the new year, the bull market that began in March 2009 is clearly intact. It is hard to find anyone who is not optimistic about stocks through at least the first half of 2011. Yet, it remains a crisis-prone environment, both at home and abroad, so I prefer to take it one month at a time and be prepared for a wide range of possible 2011 outcomes. Investors face the dilemma of short-term stock market conditions that are positive but artificial due to unsustainable government policies, and must keep a watchful eye on the horizon for signs of the next, inevitable crisis.

There are so many moving parts to the risk equation that investors cannot hope to have a sure method of knowing when to cut risk exposure. That is why holding above-average cash, despite its negative after-inflation returns, is not an unwise asset allocation decision.

The consensus outlook for another year of double-digit stock market returns in 2011 is understandable:

  • The economy appears to be gaining some momentum (though it is impossible to gauge the sustainability of an economic recovery that is dominated by government spending).
  • The Fed is openly targeting higher stock prices, and making cash and bond market alternatives unattractive.
  • Retail investors have begun to shift money back into equities, after favoring bonds for the past three years, which could become a self-reinforcing cycle that sustains the uptrend in stocks.
  • Technically, the stock market looks very healthy, given the recent breakouts to new highs, powerful momentum, and broad upside participation across all sectors and market cap segments. There is no sign yet of the technical divergences and non-confirmations that typically precede important market peaks.

Under normal circumstances, I would be inclined to join the bullish consensus and be optimistic about the 2011 stock market outlook. But these are far from normal circumstances. The U.S. financial system today is dominated by the alarming expansion of federal borrowings and hyper-aggressive monetary policy.

Government liabilities have exploded by $4 trillion in just nine quarters, which equates to $35,000 per U.S. household. Currently outstanding federal debt of $14 trillion is now 95% of the size of our GDP.

The recent stimulus package, which included not just an extension of all of the tax cuts but $300 billion of additional deficit spending, ratcheted up 2011 growth expectations and contributed to the recent rally in the stock market, but made our longer term fiscal problems even more intractable.

2010 was a year of kicking the can down the road in terms of the country’s fiscal crisis, but a new Congress with a mandate of fiscal responsibility and budget discipline was elected in November and will be seated this week. To my mind, the most important question in the markets in 2011 is whether “the era of deficit denial in Washington is over” (as the head of the Debt Commission asserted on November 30th) or whether we will have gridlock and inaction on the debt problem for two years until the next Presidential election. It would be a mistake to conclude that gridlock is good for markets. The combination of an untenable fiscal situation and a myriad of potential catalysts implies a deficit-related crisis could occur at any time.

We won’t have to wait long to assess whether the political will and leadership exist to begin to deal seriously with the country’s fiscal crisis. The Fiscal 2012 Budget Process gets underway in early February when the President presents his multi-year budget to Congress. The difference in the budget process this year is that the Chairman of the House Budget Committee is Republican Representative Paul Ryan, who is one of the most credible politicians in Washington on the issues of deficit reduction and entitlement reform and has already promised to put forth a plan to balance the budget. Rep. Ryan understands the urgency of the problem and the need to pre-empt a debt crisis from hitting the country. It remains to be seen how much importance and urgency Mr. Obama attaches to the issue, and whether he is willing to exercise the leadership that only his office can provide to forge the necessary political compromise to get something done.

2011 could also bring an inflection point in U.S. monetary policy. In recent months, risk assets have soared in no small part due to the belief that the Fed has provided a "backstop" against losses. However, we may be in the final months of the Fed-induced reflation rally. The Fed’s current $600 billion quantitative easing program (“QE2”) will expire in the spring, and it is unlikely there will be a QE3. Efforts to rein in the Fed will intensify with Ron Paul, Congress’s foremost Fed critic, now heading the House committee that oversees the Federal Reserve. It should not be hard for Rep. Paul to make the case that quantitative easing has been a failed, or at a minimum an invidious policy, given that food and energy prices are up sharply while the unemployment rate has hardly budged. It will be interesting to see what happens to interest rates when the Fed winds down its bond buying program, especially if inflation pressures continue to build. If there is a deficit-related funding crisis, short-term interest rates would spike several percentage points irrespective of the Fed.

Turning to current stock market conditions, it would be a gross understatement to say that the stock market is overbought and ripe for a correction. The S&P 500 has enjoyed four straight months without once closing below its 50-day moving average (Exhibit 1). That's such a rare feat, we've seen it only one other time in the past decade, and that was more than 7 years ago. I expect a stock market correction to begin in January that, at a minimum, will take the S&P 500 downs to its 50-day moving average (currently 1217 and rising), which would a safer entry point for any new long positions.

Exhibit 1

Another reason to avoid chasing stocks in here is the sentiment backdrop, which at present reflects extreme levels of stock market optimism and complacency. As an example, the Investors Intelligence survey of advisor sentiment shows bullishness at its most lop-sided levels since April 2010 and the bull market peaks in 2007 (see blue line in Exhibit 2). Both of these times proved dangerous for committing new funds to stocks. Other sentiment data we track, including put/call levels, measures of expected volatility, and surveys of retail investors, have moved to comparable extremes, arguing for short-term caution.

Exhibit 2

Click to enlarge

Despite the recent jump in yields, the bond market remains fundamentally overvalued. The amount of new supply from the government is exceeding the Fed’s buying program and private bond investors are worried that a bear market in bonds may be underway. The probable outcome in 2011 is for the 10-year Treasury yield to gradually rise into the 4% to 5% range. In the event of a debt-related crisis, rates across the spectrum would spike several percentage points higher than that. If the 10-year Treasury rises to just 4% in 2011 from its current level of 3.3%, investors will suffer a capital loss of approximately 5%, which will exceed the yield and result in a negative total return.

Exhibit 3

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Gold gained 29% in 2010 and is trading at all-time highs. At $1420/ounce, gold is no longer cheap insurance against a debt driven financial crisis. But as long as central banks maintain policies that debauch their currencies, and until governments address unsustainable deficits and debt levels, it is important to maintain a position in gold. GLD, the gold ETF, is in a well defined upward price channel (Exhibit 4). Investors looking to add to their gold positions should endeavor to do so when GLD moves to the lower end of this channel, which is about 8% below current levels. A potential risk to gold in 2011 is rising interest rates, particularly on short-term bonds, which currently pay next to nothing on a nominal basis and have negative yields when adjusted for inflation. Negative real (inflation adjusted) short-term interest rates have created a powerful tailwind for gold. When real rates start to move higher, gold will likely experience an intermediate-term correction.

Exhibit 4