The events of the last week or so may prove to be pivotal ones for financial markets in 2011. The two-year anniversary of the current bull market was widely celebrated on Tuesday, March 9, with many calling for a continuation of that trend based on a number of factors -- the most significant being that your typical stock bull market lasts longer than just two years, and that the third year of presidential terms are almost always favorable for equity markets.
On the other side of the debate, analysts observed recent developments characterized as "the worst since last August" -- namely, the plunge in stock prices on Thursday and a dramatic turn for the worse in the mood of the American consumer -- and wondered what could possibly be the catalyst for a sustained move higher for stocks, given that the Federal Reserve's hands are likely to be tied this year with gasoline prices careening toward $4 a gallon.
As shown below, the events of the last month bear some striking similarities to the middle of last year when, after the European debt crisis flared up in the spring, stocks and commodities sold off and consumer confidence plunged, leading to the Federal Reserve quickly switching from "exit strategy" talk in the spring to talk of "QE2" in the summer.
[Click all to enlarge]
In yet another example of the old maxim "Don't fight the Fed," it didn't take long for financial market participants to take the central bank's cues, which helped spur a rally that stretched for a full six months. During this time, stocks rose more than 20 percent and the U.S. "wealth effect" kicked into high gear, boosting consumer confidence, consumer spending, and economic growth ... that is, until inflation started to become a problem around the world, if not in the U.S. Yet.
Since last August, when Fed chief Ben Bernanke gave his now-famous speech at Jackson Hole and followed it up two months later with a formal announcement of QE2 and a Washington Post op-ed that made clear a central goal of his plan was higher equity prices, stocks haven't been the only asset that has risen.
Since the lows last summer, the oil price has risen almost 40 percent, pushing U.S. gasoline prices 80 cents per gallon higher; the price of corn has jumped more than 60 percent; wheat is now 30 percent higher; the coffee price has doubled; and cotton prices have surged an amazing 170 percent.
While the rest of the world has been feeling these price increases for some time now -- due to a shopping basket weighted more toward food and less toward consumer discretionary items -- the situation has changed dramatically in the last month. The oil price surge and manufacturers' continuing to pass along input price increases may finally start showing up this week in the official government measure of inflation, when the Consumer Price Index is released on Thursday.
Americans are now feeling the effects of rising commodity prices, and it's not just the Reuters/University of Michigan consumer sentiment survey above that reflects this. As noted in this item at the blog on Wednesday, a weekly Gallup poll showed a dramatic drop in consumer confidence in late February/early March, and the latest Rasmussen Consumer Index plunged an astounding 14.5 points over the last month; now it's back to the levels seen last August.
On the two-year anniversary of the stock bull market, hopeful analysts were careful to note that their rosy predictions came with important caveats -- like the "oil shock" quickly fading with a return to normalcy in oil-producing regions and a moderation in inflation pressures being felt around the world. They say the third year of the presidential term hasn't been a down year for stocks since 1939, due largely to the government's economic policies aimed at boosting the re-election chances of incumbents; however, others say that what we are experiencing today is anything but a normal cycle, built as it has been on massive waves of government spending and money printing that have already been carried out in recent years.
Mom and Pop investors are now back buying stocks in a big way -- oftentimes the sign of an impending top -- putting upwards of $30 billion into U.S. stock funds so far this year after pulling out almost $100 billion last year and nearly $300 billion since the 2008 financial market crash. When you read about people like Richard Dukas, head of a public relations firm in New York, -- who commented in an AP story last week, "It didn't feel right to be back in until now; I still don't want to put all my money in the market, but I believe we've come through the worst of it" -- it really makes you wonder about the longevity of the bull market, since Mr. Dukas and his wife converted their 401(k) retirement accounts into cash after the 2008 crash and now hold only 15 percent cash.
While buyers like Mr. Dukas may be the epitome of what some call the "dumb money," other investors are now selling stocks. Famed hedge fund manager Carl Icahn announced last week he will be returning all outside money from his $7 billion hedge fund -- almost $2 billion -- because he doesn’t want to be responsible for losing other peoples' money.
In a letter to investors he noted, "Given the rapid market run-up over the past two years and our ongoing concerns about the economic outlook, and recent political tensions in the Middle East, I do not wish to be responsible to limited partners through another possible market crisis."
To all but the most bullish U.S. investors, it should seem clear by now that something is amiss. Higher stock prices when gasoline prices were only $2.70 a gallon is one thing, but when gasoline costs more than $4 a gallon in parts of the country, that has an entirely different, much more dangerous, feel to it. Many are now realizing that the government's response to the credit crisis has produced a post-credit crisis economy that is anything but normal, and that massive government spending and unprecedented central bank money-printing may now be creating more problems than they are solving.
Even the IMF is now pessimistic about the current state of affairs around the world, noting in a report last week that governments have failed to address the underlying problems that sparked the 2008 financial crisis and that bad assets on banks' balance sheets are cause for growing concern -- that, perhaps, a bigger crisis was not averted, just delayed.
In the U.S., bad mortgages are a major component of bad assets being held by banks, and news last week that a record high of 23 percent of all homeowners with mortgages -- 11.1 million households -- were holding mortgages greater than the value of their homes serves as a reminder that housing remains a pernicious problem for the U.S. economy. Another 2.4 million homeowners have less than 5 percent equity in their homes and, with the trajectory of home prices in recent months, the ranks of "underwater" homeowners are set to increase sharply, raising the nation's current total of $750 billion in negative equity.
As for commodities, to some degree they are certainly different than either stocks or housing. But, as we saw just a few years ago, when investors and traders are in a selling mood, almost all asset classes are easily lumped together -- one of the defining characteristics of financial markets in recent years.
It seems there are only two kinds of assets these days: Either "risk" assets or "safe haven" assets, with gold occupying a unique position in the middle and with silver marching to a completely different drummer lately.
But, it is copper prices that have captured the attention of many market watchers recently. Just last week the metal gave up its gains for the year while closing in on a 10 percent decline from record highs reached last month. For those looking for similarities between 2008 and 2011, it's worth noting that the copper price peaked early in that year, and then only briefly recaptured those levels in June before crude oil reached a high of $147 a barrel in July.
Last week, copper prices plunged in advance of the much broader declines seen on Thursday and some think that Dr. Copper -- the metal with a Ph.D in economics, because the widely-used metal is a good barometer of economic activity -- may be signaling trouble ahead.
Other base metals saw sharp sell-offs last week, and it was the worst week of losses for industrial metals since last June. These metals are volatile, but they are also fairly reliable leading indicators for other market sectors. The fact that Chinese companies are now using copper stockpiles as collateral to secure other credit, as reported by the Financial Times, adds even greater weight to the argument that the current economic recovery is indeed shaky.
With ongoing turmoil in both the Middle East and North Africa, a possible escalation of the European debt crisis after last week's downgrade of Spanish debt, new concerns about the Chinese economy, and a myriad of potential trouble spots in the U.S., the odds of a renewed economic downturn seem to have increased considerably in just the last few weeks.
If we see anything like the events of 2008, it is unlikely that any "risk" asset will be spared and even gold will see a significant decline -- though it may fare much better than other asset classes. All assets that have been artificially supported by waves of central bank liquidity, freakishly low interest rates, and cheerleading from the highest ranks of government would give up some or all of their recent gains -- and possibly much worse.
But, even more important, perhaps, is the timing involved.
The old saw "Buy the rumor, sell the news" can be adapted to today's markets by observing that, if the Fed removes the artificial support of QE2 in June (as now seems likely) and this leads to market weakness (as is now expected), traders are probably not going to wait around for the formal announcement of the program's completion this summer. More likely -- and particularly after the events of recent weeks -- markets will begin to price in the end of QE2 long before June, perhaps as early as the week or two ahead.
More than at any time in the last six months, a heavy weighting of cash and gold seems to be a reasonable investment approach.