Not Much Good News Left to Propel Rally

Includes: DIA, QQQ, SPY
by: Jeflin's Investments

The past month has been kind to the stock market as investors hoped on to a nice lift after the World Cup distraction. August will present a tense period though in terms of market movement. While April’s high beckons tantalisingly, the stock market could fall flat or lose steam as there are not much good news left to propel the rally.

In the short term, bulls have an upper hand in momentum and risk appetite to breach minor resistance at 1120 while bears have to exert themselves strengneously for stock market indices to tumble under the 200-day moving average. In fact, some analysts expect SPX to clear 1180 before a correction.

So far it has been a good second quarter. Earnings have mostly surprised on the upside and it is encouraging to see businesses improve cashflow and repair their weak balance sheets. Huge cash hoards put them in a strong position to expand, reinvest and hire new staff.

On the economic front, things are looking up for Asian countries like Japan, South Korea, Taiwan, thanks to a robust recovery in exports. Singapore forecasted a GDP growth of 13-15% for 2010 and is set to be the world’s fastest growing economy.

This achievement is actually hollow if income levels do not rise in tandem with the cost of living. A steady growth of 3-6% in a Goldilocks environment (not too hot or cold) is better for workers and businesses. There is no point to celebrate a record year of 15% growth if Singapore report a technical recession for the next 2 quarters.

Such a weird combination is not unlikely given Singapore’s open economy which makes it extremely vulnerable to external factors. It was the first Asian country to slip into recession when the financial crisis created pandemonium in 2008. If G20 nations got ahead of themselves on fiscal retrenchment, a global slowdown is inevitable and will hit Singapore badly.

Export nations can heave a sigh of relief though as austerity measures are currently restricted to Europe which have to exhibit resolve in reducing fiscal deficits by half in 2013 and stabilize debts by 2016 to appease creditors. Austerity is not a word to associate with Ben Bernanke in the best of times and certainly not when he has declared US economic outlook to be “unusually uncertain.”

He is confident that the Federal Reserve has not run out of bullets and stands ready to resume large scale purchases of mortgage-backed securities or U.S. Treasurys when the economy deteriorates. If there is one thing to be said about Ben Bernanke, it is his determination to defeat deflation but inflation is already creeping up with his loose monetary policy.

Tipping the scale over to stagflation or hyperinflation will cause a lot of pain to savers and conservative investors but that is hardly his concern right now. There is also a US mid-term election in November so one can’t expect much political will to reduce spending or stop Quantitative Easing.

The presence of a plunge protection team and prevalent view that Ben Bernanke will only raise interest rates in late 2011 will provide a firm support for stocks and commodities, with the only casualty being the US dollar.

Besides interest rates, fiscal spending and earnings presenting little risk of changing course, investors are feeling more upbeat from stress tests. Last month, 91 euro zone banks were tested on their ability to weather a 35% downturn in the stock market. The result (84 banks were in the clear while 7 banks need to raise 27-billion euros) was better than expected and critics worry if the stress test was too lenient.

Nevertheless, it managed to shed some light on captial adequacy and extent of collapse of European banks in another “severe” recession. The renewed confidence in Europe, especially the PIIGS, has seen credit default swaps on Greek bonds sliding sharply.

Recently, Spanish banks which have been borrowing record amounts from the European Central Bank were able to raise funds from international capital markets. Stocks in Europe and the Euro had moved higher but this could be a temporary reprieve as danger still lurks over Europe sovereign debt and banks’ off-balance sheet liabilities.

To calm investors’ nerves, China has also embarked on a stress test of their own. Much has been said about a bubble forming in China’s property market as the inflated real estate prices is reminiscent of Japan in the 90s. When the bubble burst, Japan suffered a Lost Decade as the economy got stuck in a deflationary spiral. Till today, Japan’s banking system is still struggling with bad loans and investment opportunities are limited.

The wealth created by a bubble is illusory and it is hard to get back on your feet again, unless you reflate another bubble or suffer for years to eliminate the imbalance. China’s banking regulator has yet to confirm if they will set worst-case scenarios of 50% to 60% decline in real estate prices to assess banks’ fallout when homebuyers default.

Regardless of the parameters used, China’s baseline growth of 8% is safe and its stock market has already corrected substantially. There is much room to play catch up once the stress test result is out.

It is hard to see a black swan event which will bring the stock market back to its knees in the next few quarters. Now is actually a good time to allocate your portfolio strategically into stable dividends stocks and hold it for the long term. The weak US dollar trend will further boost stock market as investors shun the “safe haven” and plough into risky assets to protect their purchasing power.

Tactical play will enhance your yield if you are disciplined in buying on the dips and selling into strength to maintain your core asset allocation. However, it can be dangerous if you have itchy fingers and go long or short aggressively based purely on emotions.

The next 3 to 4 weeks may allow you to ride the bull higher but do not forget that the July rally has been operating on weak volume and the higher the stock market rises without significant volume, the greater the possibility of another flash crash. A correction, say by end August or September, is good in working off overbought conditions and bring stock market indices closer to equilibrium.

You can’t time the market as the best analysts also cannot tell with certainty where the market is headed until there is a clear breakout from April highs and July lows. Instead, just look at this consolidation period positively, in preparation for the next leg up. The longer the consolidation, the more forceful will be the break out which could occur early next year.

As for the bonds market, a revival of interest is also taking place which indicates investors are less fearful of drastic decline in bond prices as they believe interest rate hike will not be implemented soon. Corporates, municipals and governments are raising bonds and investors are gobbling them up. Can’t really blame them when inflationary pressure is building while money in the bank offers pathetic returns.

The huge US budget deficit, projected to surpass $1.4 trillion for a second consecutive year, should normally raise eyebrows among bond vigilantes but from the recent sale of two -year notes, 10-year bonds with record low yields (below 3%), the market is less concerned with government spending than with getting the economy back on track.

The huge inflow into bond market has also coincided with a huge outflow from mutual funds away from equities as investors worry about a major correction and prefer the relative safety of bonds. While we should maintain high quality bonds in our portfolio, it is worth noting that that equities will prove to be a superior investment compared to the low coupon rates in the next few years.

Sometimes we should ignore the noise and just focus on buying on the dips and accumulating slowly. It is the best approach as we are in a secular bear market and S&P 500 will not recapture the 2007 high of 1565 anytime soon. Neither will we see another crash hot on the heels of the March 2009 lows.

Make no mistake about a V-shaped recovery, it is anything but. The US economy is in doldrums and is not expected to recover its full potential for years. Two years of stimulus programs and money printing have done nothing for unemployment figures, so economic benefits have not really trickled down to households and workers.

No wonder US consumer confidence is at its worst level in 5 months but it is also good news from a contrarian perspective as more pork barrels have to be handed out…