What Was Behind the Halloween Rally?

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 |  Includes: DIA, QQQ, SPY
by: James Picerno

In the wake of Wednesday's 25-basis-point cut in interest rates by the Federal Reserve, the not-so-subtle message is that the economy will weaken. But the cut came just hours after the Bureau of Labor Statistics told us that economic growth was higher than expected in the third quarter at a respectable 3.9%. Not only is that slightly faster than the annualized real 3.8% growth in the second quarter, that's the fastest pace since Q1 2006.

Of course, no one expects that the 3.9% is a prelude to something better, or even the standard for the foreseeable future. The Fed, to cite one source, expects the economy to slow. If a downshift is coming, diminished consumer spending will be the reason, probably due to the ongoing fallout from housing.

But there was no sign of that in Wednesday's GDP report. In fact, personal consumption expenditures, which are GDP's driving force, jumped 3.0% in Q3. What's more, consumer purchases of durable goods rose at an even faster pace, ascending 4.4% which is well above the economy's overall rate of expansion.

For the casual observer only looking at the numbers, this may not look like the onset of trouble. Yet, the Fed's expecting something less than perfection. Indeed, the central bank is now convinced that the odds of a slowdown, or worse outweigh the risk of inflation or the fallout of what lower interest rates will do to an already battered dollar.

In it's FOMC statement on Wednesday, the Fed explained that:

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.

If so, then there's more to worry about with oil continuing to trade above $90 a barrel. The only thing worse than a recession is one that comes with record-high oil prices. No wonder then that the Fed remains wary on the inflation front as well, even if it's not yet prepared to do anything about it. The Fed statement also advised that,

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.

Being that Wednesday was Halloween, one could have forgiven the stock market for thinking this all added up to an October 31 fright. In fact, stocks found reason to rally. The combination of lower interest rates and a still-robust economy (at least when viewed in a rear-view mirror) looked compelling to Wall Street.

But as we've all learned anew in recent months, economic numbers aren't always what they appear to be on the first blush. The future, of course, will unfold in only one way. Alas, the possible paths are numerous, and handicapping the odds of one vs. another isn't getting any easier. It's easy to think that the path will continue to favor the bulls. Indeed, recent history offers only inspiration. All the major asset classes continue to roar. But that, we fear, is an extraordinary trend nearing its end.

Something has to give. We don't know what freshly minted statistic will break the camel's back, nor do we have a clue when it'll arrive. But the age of handsome returns as far as the eye can see won't last. The world just doesn't work like that, even if recent history suggests otherwise.

In fact, that dark outlook gives us hope as long-term investors because it will offer the opportunity to buy at lower prices, thereby dispensing higher expected returns that come with lower prices when dealing in broad asset classes. Exactly how this scenario will unfold is still a mystery - which asset class or classes will stumble and when? Such a great unknown is uncomfortable from an investment perspective. Then again, history suggests that comfort rarely goes hand in hand with maximizing returns in the long run.