I have to admit I was surprised by last week’s huge stock market rally.
The Dow Jones Industrial Average soared nearly 650 points in five trading sessions, while the S&P 500 gained 5.6% and the Nasdaq Composite rose 6.2%.
Yet maybe because I didn’t expect it, I just don’t trust it. So much movement on so little volume — and not much news to drive it, except the latest tentative settlement on Greece.
And until Tuesday, oil and gold — two of the primary movers in the “risk-on” trade that drove the market from its lows of last summer — either barely participated or fell.
That’s one reason I suspect, but can’t prove, that the stock rally was dominated by pros looking to push up prices and exit their positions ahead of earnings season. [For ways to protect your own profits this summer, read my recent column here.]
I’m still pretty cautious about the market this summer. Unless we see big improvement in the economy, which I don’t anticipate, the fundamental underpinnings are pretty weak. And there’s little prospect of the massive government and central-bank interventions that helped drive stocks higher last year.
I can see four barriers to the market’s progress in coming months:
- The economy
- The European debt drama
- The debt ceiling debate in the U.S.
The market must clear these hurdles before it can move beyond its late-spring highs.
Reporting season is almost upon us and we’ve seen six consecutive quarters of double-digit earnings growth. That’s likely to continue this time around as well (analysts project 12% increases over last year’s second quarter), although just beating estimates is having diminishing returns.
Why? Because first, it’s expected. Second, companies have been, ahem, managing earnings so they usually come in just a hair over consensus, enough to give stocks a nice pop. Uncanny!
Even the bullish James Paulsen, chief investment strategist at Wells Capital Management, isn’t looking for much from earnings season. In a note to clients, he said this season “could disappoint” because it reflected a soft patch in the economy caused by disruptions from Japan and bad weather.
He thinks margins have probably peaked, which he calls normal at this point in the cycle.
“So, [investors] may look toward company commentary/expectations about [the second] half as the more important information," he concluded. Indeed, executives’ outlooks on the rest of the year will get the closest scrutiny.
“'Second-quarter earnings are going to be fine, but the guidance is going to be awful,’” Burt White, managing director and chief investment officer at LPL Financial, told the Financial Times, which added, “lower guidance from companies might cause analysts to reassess their record $100 per share full-year earnings forecast for the S&P 500.”
That brings us to hurdle No. 2, the economy, which has stumbled badly. U.S. gross domestic product grew at an annual rate of only 1.8% in the first quarter, way below economists’ earlier projections of 3.2% growth for 2012. May’s survey of manufacturing activity had its biggest one-month drop since 1984.
We may indeed be going through a soft patch, with growth slated to pick up in the second half, but this recovery remains by many measures the weakest since World War II.
And small businesses, the biggest job creators, face tight credit and skittish customers, so they aren’t doing much investing or hiring.
Last week, the respected economist Lakshman Achuthan, head of the Economic Cycle Research Institute, told Jon Markman that “employment growth has peaked for this cycle” as we move into a cyclical slowdown.
“’That was as good as it’s going to get,’” he said. With 9.2% official unemployment — and much, much more unofficial unemployment — that’s pretty scary. And Friday’s shockingly weak June employment report only underscored the problem.
Meanwhile, as I’ve written here before, policymakers have run out of tools — both fiscal and monetary — to pump up the economy. And if President Obama thinks he’s going to get any more “stimulus” through Congress, he’s living in a dream world. [Read how investors graded President Obama's handling of the economy on The Independent Agenda.]
So don’t expect a repeat of last year, when Federal Reserve chairman Ben Bernanke announced his second “quantitative easing” program in late August, sending stocks on a 30% run that lasted through the end of April.
The third hurdle for the market is Greece and the Eurozone’s other poor cousins. Last week’s passage of tough austerity measures by the Greek parliament, despite rioting in the streets, should take the heat off for a while.
But it won’t forestall what many think is inevitable: Greece’s default on its obligations to creditors. And the government’s austerity measures may make things worse by cutting the economic growth Greece needs to boost tax revenues. A vicious cycle, in other words.
Credit-default swaps, which insure against default, came down a bit from their peak last week, but still cost more than $2,000 a year for $10,000 worth of Greek sovereign debt.
That’s bad news for the German and French banks that hold a lot of Greece’s debt. Those banks are also heavily into Spain and Portugal, whose debt was quietly downgraded to junk status by Moody’s this week.
Here’s the deal: Both Greece and Portugal are basket cases, as is Ireland, in which British banks have a big exposure. But nobody wants to use the “d” word for fear of starting another financial contagion. So, these economies are dying of cancer rather than a massive heart attack. And that’s having a less dramatic effect on markets.
The S&P fell about 16% in the midst of last year’s Greek crisis. This year, it loss less than half that. Investors are getting more accustomed to the problem, which means any surprise — like unanticipated issues in Spain — could cause stocks to take a big hit.
As could our own debt ceiling negotiations, the market’s fourth big hurdle.
The Debt Ceiling
The August 2 deadline for raising the debt ceiling is rapidly approaching and predictably, Washington DC is enmeshed in a high-stakes game of brinkmanship. Amid some signs of Republican compromise on ending some tax breaks and following Democrats’ concessions on spending cuts, I think we’ll have a deal by that deadline.
But we could have some nasty ups and downs before that happens, which could take the market on a roller-coaster ride. And if we don’t get a deal, all bets are off. [Read more about the possible effects here.]
I don’t know if we’ve been in a correction that’s over, a bear market that’s beginning, or the start of a new bullish move. But I’m glad I followed my own advice this spring and took some money off the table. I’m still substantially in the market, so I’ll participate in any further advances, but if stocks fall again, I won’t kick myself for not taking profits when I could.
Because this market has some big hurdles to clear over the next couple of months and the race is just beginning.