Why stocks may post surprising gains in the months ahead:
- The pattern of risk-off followed by central bank-induced risk-on is alive and well.
- Inter-market relationships look similar to the pre-melt-up period in 2009, 2010, 2011.
- The European Central Bank (ECB) is readying for serious market intervention.
- More money printing is coming from the Fed.
- Oil and commodities have perked up according to the pre-melt-up script.
- China may respond to weak economic data with more stimulative actions. According to a CNBC report published on Friday, "action by China's central bank could come as early as the weekend."
Over the next few weeks, another Fed and ECB liquidity party may be coming to a market near you. Will you recognize the clear pattern below this time?
- In late 2008/early 2009 the financial system was on the ropes. The central planners stepped in with TARP, taxpayer bailouts, and massive amounts of money printing. Stocks took off.
- In early July 2010, fears of deflation had investors running for the exits. The Fed hinted at QE2 in late August. Stocks took off.
- In the fall of 2011, with Europe on the edge of the abyss, the European Central Bank offered unlimited three year loans to banks, making the Fed look like a money-printing piker. Stocks took off.
See a pattern here? In 2012, the Fed has again hinted at another round of quantitative easing or QE3. In 2010, Mr. Bernanke delivered the knock-out blow to the bears on August 27 during his Jackson Hole speech. For those scoring at home, Mr. Bernanke's annual visit to Jackson Hole is just a few short weeks away. Many took the "QE won't have an impact" stance in 2010. The S&P 500 (NYSEARCA:SPY) gained 28% after QE2 was signaled at Jackson Hole, which in our mind is an "impact."
The real and potentially melt-up-inducing news has been coming from the European Central Bank. On August 6, we noted a few European hurdles still need to be cleared before another round of massive money printing can be launched. Coupled with resistance the S&P 500 faces near 1,400, the door may be open for one more scary pullback before central banks kick off Monster Rally 2012.
Since we are at least a few weeks away from Fed and/or ECB action, the Europeans have been sending up numerous "don't mess with us" warning flares to calm bond market waters. The most intimidating comments for the bears came from Michael Meister, deputy parliamentary leader of Angela Merkel's Christian Democratic Union party in Germany. From Bloomberg:
Draghi's statement that the ECB is prepared to step in to help lower borrowing costs in Spain and Italy sends a warning to investors not to speculate against the single currency, said Meister. He cited the example of George Soros, who made $1 billion in 1992 betting the U.K. would be forced to devalue the pound, saying similar such bets against the euro would fail. "If Mr. Soros tried it with the British pound, he shouldn't try it with the euro after this reference by Mr. Draghi," Meister said. Draghi sent a message to "all speculators who think that they can speculate against the euro: My dear friends, be careful, there's somebody in the background who may join the game and his pockets are deeper than your pockets."
On the heels of the "deeper pockets" reference above, we have adjusted a popular adage for our centrally planned financial system:
Fool me once, shame on you; fool me four times, shame on me.
As money managers, we grew tired of the recurring central bank whipsaws. Consequently in early 2012, we developed a new "faster" market risk model. The new model helped us become open to a rally attempt in stocks as the S&P 500 approached 1,266 earlier this year. We outlined the basis for our optimism in a May 25 video. The S&P 500 has tacked on 141 points since the video was posted.
Mr. and Mrs. Middle America are hiding in what they feel is the safe haven of U.S. Treasury bonds. They might want to look at the 09:50 mark of the video below, which shows a 22% drop in Treasuries (NYSEARCA:TLT) that occurred under similar circumstances in 2009. The video also shows numerous inter-market set-ups that have foreshadowed past melt-up rallies in risk assets. If you can recognize a pattern of any kind, you do not need to understand technical analysis to have several "that looks similar" moments while viewing the video. If you want to avoid possibly being fooled again, the video is worth a look.
After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.
Melt-up rallies in 2009, 2010 and 2011 all experienced multi-week corrections in the early stages of their development. With numerous forms of resistance sitting between 1,400 and 1,415 on the S&P 500, we still have a small hedge (NYSEARCA:RWM) in place to offset our longs. We noted back on July 3 that oil and oil stocks were well positioned for a rally. Since then, the Market Vectors Oil Services ETF (NYSEARCA:OIH) has gained 10.81%. As shown in the table below, stocks highlighted on July 3 as having bullish set-ups have also performed well:
Given the valuation picture, we continue to favor foreign stocks (NYSEARCA:EFA) relative to U.S.-based companies. Asia's benchmark stock index trades at 12.3 times estimated earnings, compared with 13.6 for the S&P 500 Index and 11.6 for the Euro Stoxx 600 Index, according to data compiled by Bloomberg. That means European stocks would have to outperform the S&P 500 by roughly 17% to "catch up" from a valuation perspective. Said another way, companies are significantly cheaper in Europe right now.
Meanwhile, the European Central Bank (ECB) is preparing to address (at least in the short-run) the biggest bearish drag on European shares. From Reuters:
The European Central Bank is determined to bring down excessive risk premiums for member states in bond markets and should be ready to act very soon, ECB governing council member Christian Noyer said on Thursday.
From an intermediate-term perspective, we like China (NYSEARCA:FXI), emerging markets (NYSEARCA:EEM), Germany (NYSEARCA:EWG) and even have a small stake in Italy (NYSEARCA:EWI). The markets are vulnerable to a pullback in the short-run, but the longer-term picture still looks positive. Greece is one candidate to derail our year-end rally hypothesis.
As described in a series of October 2010 "how QE works in the real world" videos, quantitative easing is designed to "pump up" asset prices by injecting money into the global financial system. The global financial system is a politically correct term for global brokerage firms, not traditional banks where the Fed's printed money will "just sit around doing nothing."
The melt-up/melt-down pattern has been established. With a big wild card in the form of Greece, an open mind paired with flexibility remain important from a risk management perspective. At some point, the central bankers will print and the deflationary forces will be too strong to overcome. Based on the set-ups described in the video above, we have not yet reached that point. Melt-up 2012 could begin sometime in the next six weeks.