The stock market entered a period of long-term volatility in 2008 that continues today. Excessive debt is providing a significant impediment to renewed structural economic growth…
click to enlarge
…while the Federal Reserve is injecting liquidity into the system at an historic rate...
…creating massive imbalances that are driving extreme moves in both directions.
In early 2011, our analysis indicated that the second quantitative easing program was fully priced into stocks and that the market would likely struggle for the remainder of the year. Additionally, we forecast that the extreme rally from late 2010 would be followed by a severe correction. As expected, the S&P 500 index experienced a violent decline in July and August before closing unchanged for the year. In early 2012, we find ourselves in a similar situation following another extreme rebound off of the low in October 2011.
The S&P 500 index has gained 27 percent during the last five months, while the economy continues to struggle and other markets, such as Treasuries, signal caution through negative divergences. The stock market is pricing in a return to strong economic growth, even though that scenario is highly unlikely given the significant structural headwind presented by excessive debt.
Although the fast and furious moves in risk assets such as equities "feel" very good over the short term, it is critical to remember that gains fueled primarily by government stimuli can be erased just as quickly as they appear. As always, short-term market behavior only has meaning when analyzed in the proper context afforded by the big picture. The cyclical bull market in stocks from 2009 is almost certainly in the final stage of its development, so now is a time for extreme caution from an investment perspective.
The stock market will likely provide a meaningful signal with respect to long-term direction during the next two months, so it will be important to monitor price behavior closely.