Despite the robust rally stocks have enjoyed since the Fed began cutting interest rates on August 17 and the recent move by large-cap U.S. stock averages to new record highs, we remain suspicious of this market. At best, the stock market is badly in need of a correction before a sustainable leg higher can occur. At worst, the rally from the mid-August low is close to exhausting itself and marking an intermediate term top in stock prices. In any case, we perceive more risk than potential reward in the stock market at the present juncture. The basis for our defensive posture is as follows:
1. Misplaced confidence in the Fed. By reversing its monetary policy in August and surprising the markets with larger than expected rate cuts (first in the discount rate and then in the fed funds rate) the Fed appears to have been successful in the short term in reflating stock markets and stabilizing credit markets. However, the Fed’s ease has also sent the U.S. dollar on an unrelenting slide to record lows which has stimulated a large rally in commodity prices (oil is now trading at a record price of $85/barrel).
The bond market has not failed to take note of these inflationary developments. The 10-year Treasury yield has rallied nearly 40 basis points off its recent lows, and is now trading at a meaningfully higher level than when the Fed cut the federal funds by 50 basis points on September 18. The bear market in housing was a principal concern cited by the Fed as a justification for easing policy. At the time, we pointed out that the problems in the housing market of record supply and inflated prices were not going to be solved by the Fed manipulating the overnight lending rate.
The borrowing rates that matter to the vast majority of mortgage holders are intermediate to long-term interest rates, which are determined by the market not the Fed. At present, the bond markets that set these longer-term interest rates are reacting negatively to the inflationary backdrop, which has deteriorated as a result of the Fed’s actions.
2. Highly uncertain economic outlook. In our judgment, the economic outlook is as uncertain as it has been since this bull market in stocks began five years ago. The bear market is housing, which shows no signs of a bottom, an unstable credit backdrop, a persistent inflation problem, and the continual debasement of the U.S. dollar (still the world’s reserve currency.) creates a formidable set of risks to the economic outlook, to say nothing of geopolitical risks in the Middle East. Although the buoyant stock market is suggesting no imminent risk of recession, we would rather play it safe at this stage of the economic and market cycle and err on the side of conservatism.
3. Negative divergences in stock market. Despite the powerful rally of the past two months, there are a number of negative divergences in the stock market that should be resolved if the market is about to embark on a new leg higher in this bull market. The new highs that have been achieved by the U.S. large-cap averages (e.g. the Dow Industrials and the S&P 500) have not been confirmed by the broader market or by breadth indicators. The small cap indexes and the NYSE advance-decline line have thus far failed to make a new high. We would want to see an improvement in market breadth and also more convincing signs of a bottom in the real estate and banking sectors before becoming more bullish about the intermediate term prospects for the market.
4. Sentiment becoming frothy. Investor sentiment is moving rapidly towards excessive optimism. The latest Inventors Intelligence survey reflects 60% bulls and only 21% bears, essentially a three to one ratio of bulls to bears that has historically served as a sell signal. Similarly, the latest survey of the American Association of Individual Investors produced a reading of 55% bulls (the highest bullish reading since January) and 26% bears. Reinforcing these sentiment surveys, the put/call options readings are near their worst (i.e. excessive optimism) levels of the past several years, and retail speculation in stocks traded on the Nasdaq exchange has reached its highest level in three years.
Given the risks enumerated above, our present level of equity exposure is right in line with our comfort level.