50 Shades Of Stock Market Grey

by: Eric Parnell, CFA

Investors and the stock market have been bound in a tawdry affair over the last several years. But like so many relationships marked by heightened tensions and unpredictably dangerous behavior, investors risk a most tumultuous ending from this ongoing entanglement. It has never been a question of if, but more of when. In the meantime, this relationship appears ready to continue drifting higher.

The journey for stocks over the last several years has been shocking to say the least. After touching an all time intraday high on October 11, 2007 of 1576 on the S&P 500 Index (NYSEARCA:SPY), stocks soon descended into darkness. Over the next 17 months, the stock market was stripped of -58% of its value before reaching a final intraday bottom on March 6, 2009 of 667 on the S&P 500. But since this time, stocks have engaged in a lusty +121% rally that has brought the market back as close as 7% from its previous all time highs at 1474 on the S&P 500 in recent weeks.

Unfortunately, the rally that has brought us so far back to near previous heights is without any solid foundation. Back in early March 2009, the following significant concerns had the market transfixed in fear and provided investors with the justification to push stocks to uncomfortably lower bounds:

  • Excess debt and leverage across the global economy
  • Uncertainty over the implications of unprecedented monetary policy actions
  • Potential instability in the eurozone due to countries with vastly divergent fiscal circumstances sharing the same monetary policy
  • Threat of a tax increase on high income earners to try and offset ballooning budget deficits
  • Potential calls for protectionism in order to promote domestic economic activity
  • Risk of the flow of global credit drying up

One would likely feel comforted today in a stable and sound relationship with stocks if meaningful progress on the above issues that helped drive the market to March 2009 lows had been addressed along the way. After all, one of Fed Chairman Bernanke's primary justifications for QE1 during his 60 Minutes appearance just nine calendar days after the market bottom on March 15, 2009 was that such extraordinary policy actions were required to buy more time to attempt to fix these issues.

Unfortunately, virtually none of these conditions are better nearly four years on. Instead, the situation has actually unraveled even further. Moreover, many of the prevailing concerns at the March 2009 lows not only remain unaddressed, but are also part of the active political dialog and are up for consideration today.

  • Excess debt and leverage: While private sector debt levels have improved since the depths of the financial crisis, public sector debt conditions have deteriorated significantly. Whereas U.S. debt-to-GDP was roughly 62% prior to the crisis, it is worryingly high at over 100% today. And the public debt situation in many other parts of the world including Europe and Japan has exploded to potentially destabilizing levels.
  • Uncertainty over monetary policy actions: The U.S. Federal Reserve has injected over $2 trillion in liquidity into the economy. And virtually every other major global central bank has followed suit with massive stimulus program. All that we have to show for these efforts so far is a sluggish economic recovery at best. But what happens if the mountain of excess reserves sitting on the sidelines suddenly gets unleashed into the system? And even if the Fed acts swiftly to fight the inflationary fight and quickly drains liquidity out of the system, this is a process that will not be without considerable pain for the markets.
  • Potential instability in the eurozone: These worries back in March 2009 have come to pass in a dramatic way. Remember when investors wrung their hands over Latvia and Dubai in the early days of the financial crisis? Seems almost humorous in retrospect, as the crisis quickly escalated in both size and scale first to Greece and then Portugal and Ireland and on to Spain and Italy. Whether the next stop is France remains to be seen. But what was once conjecture is now harsh reality.
  • Potential tax increase on high income earners: In just over two weeks, the U.S. may re-elect a president whose main policy strategy to address the budget deficit is to raise taxes on those making over $250,000 per year in income. In addition, we stand only a few months away from going over the fiscal cliff, which would entail what would effectively represent massive tax increases and spending cuts across the board. And the French recently unveiled a super tax of 75% on those earning more than 1 million euros in income.
  • Calls for protectionism: While it is considered extremely doubtful that either candidate would actually follow through with their stated objectives during the campaign, both President Obama and Governor Romney have been talking openly about pursuing trade sanctions against China. Despite these calls, the inclination toward protectionism has remained limited to this point.
  • Global credit drying up: It is this last worry in particular that has the potential to completely unravel global financial markets into another crisis phase. We have stood at the precipice a few times since the outbreak of the financial crisis, most recently at the end of November 2011, but policy makers appear to remain intent on fighting this impulse at all costs. Whether they have the unlimited flexibility to do so still remains to be seen.

In short, none of the key concerns that drove stocks to their March 2009 lows has been fixed. Instead, most have become much worse and the remaining few that have not are still at extreme risk of deteriorating.

Yet despite the fact that what once were worries have now in many cases become realities, we have a stock market that is thrusting its way toward all time highs.

So where do we stand today with the economy? After nearly four years of a sluggish recovery, many segments of the global economy are threatening to fall back into recession if they are not already there. Also, while the U.S. economy has added 4 million new jobs since the post crisis lows, we are still over 4 million jobs below pre crisis levels and have seen an 8 million increase among those not in the labor force, which is well above the historical trend rate of increase. Inflation pressures remain in check, but far from what would be considered stable, as the risk of crippling deflation still looms large as well as threat for rapidly rising inflation. And corporate earnings growth is stalling with profit margins already at post WWII highs.

Even without the overhang of crisis concerns mentioned above, all of the prevailing economic forces today point to a stock market that should be in decline. But once again, we have a stock market that is remains infatuated with achieving ever-increasing heights.

So if already unstable economic and market conditions are becoming increasingly tumultuous, what exactly accounts for all of the stock market gains that we have experienced over the past few years? The key driver has been monetary stimulus from global policy makers including the U.S. Federal Reserve. For when the Fed has been applying QE or when the European Central Bank has been in the midst of a balance sheet expanding LTRO program, the stock market has at worst held steady if not risen sharply with little interruption. But during the brief periods since the aftermath of the financial crisis when the stock market has been without such monetary stimulus support, the stock market has fallen a collective -26%.

This fact has extremely important implications for the stock market today. Investors remain besotted by the notion that QE from the Fed will lift markets higher no matter how other economic or market forces might suggest otherwise. This, after all, was the key premise that drove the market +15% higher from its early June lows to the day the Fed announced open ended QE3 in mid-September. For without the hopes for more QE from the Fed, stocks would have likely continued much lower through the summer, not higher.

And this highlights the extraordinarily key risk for stocks today. If hopes and expectations based on QE is truly the only reason that stocks are trading at current levels, what happens if investors someday discover that markets no longer drift higher under the influence of QE? What if the primary reason that the stock market has traded so much higher over the last several years is removed as a factor to support further gains? What then for the stock market when all hope is gone? A long, slow grind lower to the true market price equilibrium is one possible outcome. Another is a more rapid descent to true price levels or below. Regardless, the risks associated with any such a development must be watched carefully and closely at this stage of the post crisis rally.

So where exactly do we stand with today's stock market? Despite the recent volatility since the Fed's announcement, blind QE driven hope continues to reign supreme. Yes, stocks plunged by -1.6% on Friday, but even with this sharp drop they still ended higher for the week. And while stocks continue to thrash back and forth since the Fed's QE announcement just over a month ago, they continue to hold support at its 50-day moving average (blue line below), which remains critical technical support level. And even if this support fails, the stock market also has support at its previous highs at 1422 on the S&P 500 (green horizontal line) as well as at its 200-day moving average (red line).

click to enlarge image

Thus, this steamy stock market relationship remains ongoing. And just like the bestselling book 50 Shades Of Grey, while most investors may be left feeling uneasy if not disturbed by the content, many are compelled to stay with their stock market book not only because of the gains seen over the last few years but also for not wanting to miss out on any further advance even if the reviews by most experts remain mixed to negative.

The love-hate relationship that so many investors currently have with the stock market leads to a natural question. How can you best participate in any further upside while keeping things as clean and risk controlled as possible?

This strategy, of course, includes an allocation to stocks. But any stock exposure should be held in proportion to other asset classes for protection. And emphasizing defensive allocations within the stock market can help guard investors from the more seedy elements that they might rather avoid. Diversified offerings such as the S&P 500 Low Volatility PowerShares (NYSEARCA:SPLV) and the Utilities SPDR (NYSEARCA:XLU) provide focused allocations to the higher quality, lower risk areas of the market. And a concentration on specific names or themes that tend to perform best during QE phases such commodities producers like BHP Billiton (NYSE:BHP), Occidental Petroleum (NYSE:OXY) and Potash Corporation (NYSE:POT) is also warranted. Selected emerging markets (NYSEARCA:EEM) such as China (NYSEARCA:FXI) and Brazil (NYSEARCA:EWZ) are also worth consideration in this same context, as both are heavily concentrated in the commodities space. Moreover, both China and Brazil have underperformed the U.S. stock market since the summer of 2011 and are overdue to close this returns gap.

Beyond stocks, even better opportunities reside in some more stable and predictable areas of the investment universe. Gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) offer great appeal for their multi-faceted defensive characteristics, as they provide crisis protection to the downside as well as protection against inflation and seemingly endless money printing to the upside. I prefer to hold exposure to these precious metals via the Central Fund of Canada (NYSEMKT:CEF) and the Central Gold Trust (NYSEMKT:GTU). And other more consistent categories such as U.S. TIPS (NYSEARCA:TIP), Municipal Bonds (NYSEARCA:MUB), Agency MBS (NYSEARCA:MBB) and Build America Bonds (NYSEARCA:BAB) help keep a portfolio on a more straight and steady path.

Investors and the stock market remain wrapped up in an incendiary affair of money printing and rising stock prices. Some day, this relationship will end badly, and this outcome will ultimately help lead stocks to a healthy new beginning marked by a return to fundamentals and prices that have finally returned to equilibrium. In the meantime, those that choose to flip through this current stock market book should do so with a meaningful degree of caution and risk control, for one never knows exactly what the next page will bring.

Disclosure: I am long BHP, OXY, POT, FXI, EWZ, SPLV, XLU, GTU, CEF, TIP, MBB, MUB, BAB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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.