"What a long strange trip it's been"
-Truckin', Grateful Dead
The stock market got off to a rousing start in 2012. But despite robust gains in the first quarter, stocks have recently shown signs of weakness. More significantly, substantial questions remain about the sustainability of these gains in the coming months. Thus, it is worthwhile to examine the road map of what we might expect for the remainder of the year.
You don't know where you're going until you know where you've been. And the past two years of 2010 and 2011 are particularly instructive in determining what we might expect for the rest of 2012. Of course, the previous two calendar years were both defined by one dominant theme - the forces of monetary policy stimulus. A brief review of the past two years highlights the significance of these effects.
Back in 2010, stocks started the year by completing what was a meteoric rise from the March 2009 lows. By the end of March when the Fed's first quantitative easing program (QE1) was drawing to a close, confidence was brimming that an economic recovery was underway and speculation was building around the timing of Fed interest rate increases and soaring bond yields. But once QE1 ended, stocks quickly fell apart and the realization abruptly set in that any recovery was on the most fragile footing without a steady drip of monetary adrenaline. By the beginning of July, Fed policy makers were out on the speaking circuit openly hinting that additional stimulus measures may soon be in the offing. This stabilized the market into a choppy sideways pattern for the next two months. And once Fed Chairman Ben Bernanke took the podium at Jackson Hole in August 26, 2010 with explicit words that QE2 was soon on its way, stocks were off and running again for the remainder of the year.
The influences of monetary policy were just as pronounced in 2011. Stocks continued to levitate on a QE2 high for the first several months of the year. But as the realization increasingly set in that the stock market may suffer a similar fate to that of the previous year once QE2 ended, stocks began to thrash back and forth. And once QE2 concluded at the end of June, it was only a matter of weeks before stocks were cascading lower in the latest convulsions of a market that had was once again without its monetary sedatives. The Fed wasted little time this second time around, quickly rushing back in with more promises of policy support and allusions to further stimulus coming soon. This stabilized the market long enough for Operation Twist to finally arrive in early October to soothe the market through the end of the year. But this time around, the real boost to stocks came from overseas starting mid December in the form of the European Central Bank's (ECB) Long-Term Refinancing Operation (LTRO). This ECB program basically flooded trillions of dollars into the system, which set stocks on a brand new trip higher for the next few months.
This brings us to 2012. Stocks continue to drift dreamily higher, but the monetary drugs are showing signs of wearing off once again. The second and final (at least for the moment) LTRO from the ECB was completed at the end of February. And since stocks have been left with just Operation Twist as their only major stimulus support, they have started to shown some signs of meaningful fatigue.
So given this history, what can we expect from the stock market for the remainder of the year? All else equal, it is a trip that plays out in five parts.
The first is the winding road. The market has been on this path since the beginning of April. And this road is likely to run through the end of June when Operation Twist comes to an end. Stocks recently peaked at roughly 1420 on the S&P 500 before entering into correction, and it would not be a surprise to see stocks revisit if not exceed this recent high in the coming weeks. After all, if stocks can completely disregard the highly disturbing economic news both here and abroad the way they did last week, they should be able to continue enjoying periods of floating higher on monetary stimulus while it lasts over the next nine weeks. However, if the situation in Spain begins to deteriorate at an accelerating rate or if the elections in France or Greece suggest the policy status quo may soon be disrupted, stocks may be quickly sent on a detour.
The second is a steep descent. This would most likely arrive in mid to late July and continue into August. Although Operation Twist concludes at the end of June, this does not mean that stocks will immediately fall into correction. Instead, stocks have historically rallied for the first 15 trading days on average after the end of previous Fed stimulus programs as the final shots of adrenaline wear off. But the subsequent decline could be severe, particularly if the Fed is not providing any signals of further policy support along the way.
The third is another winding road at a lower market elevation. If the markets begin to sell off precipitously, the Fed will likely have increased flexibility and political clearance to carry out additional stimulus. But just as they have in the past, instead of intervening immediately, they will likely use the power of the podium first to try to soothe the market back to life first without actually applying any stimulus. This would likely send stocks into another choppy sideways pattern through late August and early September. But in the end, however, the market would likely force the Fed's hand to act.
The fourth is the steep ascent. From the moment a new Fed stimulus program is launched, the stock market enters back into a euphoric state. And the same should be expected this time around regardless of the fundamental economic and market backdrop. That is, of course, unless the global situation has deteriorated to the point where the magnitude of Fed policy is no longer sufficient to offset the downside forces that continue to boil underneath the surface. Moreover, the rally may prove fleeting this time around for reasons that are out of the Fed's control.
The final stage of the trip is marked by icy roads ahead. While monetary policy has been a driving force for the stock market over the last few years, fiscal policy has also played its part. And the United States is currently scheduled to drive off a fiscal cliff at the end of 2012 as many of the current stimulus programs are set to expire. And given that it is a Presidential election year, nothing is likely to happen from either side of the aisle on this front until mid November at the earliest. In other words, a massive amount of work to avoid a major shock to the U.S. economy is not even going to begin until the last few weeks of the year at a time that will include two major holidays and a good number of politicians that may have recently lost their jobs in Washington. This is not the type of uncertainty that builds confidence in investment markets. As a result, the end of the year could be highly slippery for stocks regardless of what is underway on the monetary policy side.
So what is the best investment strategy given such windy stock market roads? The best is to take the alternative path and stay hedged. A variety of asset classes have shown the ability to perform well regardless of what the Fed is doing at any point in time. And these same categories also stand to benefit from their defensive characteristics. These include Gold (GLD), U.S. TIPS (TIP) and Agency MBS (MBB). Nominal Long-Term U.S. Treasuries (TLT) also offer appeal, particularly during periods when the stock market appears poised to enter into correction.
Of course, it is equally important to maintain exposure to the stock market given the potential that it may continue to levitate behind further injections of monetary stimulus. But given that risks are to the downside for stocks at this point, focusing exposures to more defensive areas of the market including those that have shown the propensity to hold up well during corrections has merit. Representative names include McDonald's (MCD), HJ Heinz (HNZ), Tootsie Roll (TR) and WGL Holdings (WGL) as well as the broader Utilities sector (XLU).
It has been a long strange trip for the stock market over the last few years, and 2012 promises to deliver more of the same. Keep your hands on the wheel and your eyes on the road ahead, as conditions could become increasingly tricky for the remainder of the year.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.