Stocks: The Hunt For Progress Since October

by: Eric Parnell, CFA

It was a market tale being told over 200 S&P points ago.

The date was October 4, 2011. Stocks had already fallen sharply in the days following the end of QE2 on June 30, 2011. After fighting to hold support since early August at 1100 on the S&P 500 (NYSEARCA:SPY), the stock market finally broke decisively to the downside. By mid-morning that day, the S&P 500 dipped as low as 1074. The key issue at the heart of investor concerns was the increasingly deteriorating financial crisis in Europe and the potential for spillover effects into the U.S. and global economy. As the fourth quarter began, the situation in Europe appeared dire, and the stock market was fully reflecting it.

Everything suddenly changed during the final hour of that same trading day. Stocks were descending toward the lows of the day by the late afternoon of October 4 and it appeared that stocks may be ready to take another leg down to close on the lows of the day. But in the final minutes before the close, the mood shifted dramatically, as stocks swiftly jumped off their lows and skyrocketed higher. By the close of trading on October 4, stocks ended up +2.2% at 1123. And in the months since this pivotal day, stocks have been working their way higher ever since.

If concerns over Europe managed to push the S&P 500 -20% lower from 1345 at the end of July to 1074 by early October, the fact that stocks have climbed all the way back to 1295 just this past week must indicate that everything is now better with Europe. Right? After all, it wouldn't make sense for the stock market to make it all the way back to previous levels if Europe was the primary cause for stocks to drop in the first place. Right? Wrong.

We live in extraordinary times for investment markets. And only in this post crisis market driven by factors that clearly extend well beyond fundamental and technical factors and seemingly defy logic can we see such a wide divergence between "reality" and "hope".

Through Friday, stocks as measured by the S&P 500 Index have risen by +20% from the October 4 intraday lows. It is worthwhile to examine how the variety of market indicators have moved over this same time period to see if they are supportive of this explosive market advance.

10-Year U.S. Treasury Yield

The 10-Year Treasury Yield can be viewed as a safety indicator for investors. The lower the yield, the more investors are demanding safe haven protection. The 10-Year Treasury Yield touched a low of 1.72% on October 4. On Friday, the 10-Year Treasury Yield closed at 1.85%. Thus, the 10-Year Treasury Yield are very similar, as both readings are well below 2%, which suggests that the recent rally in stocks cannot be explained by an increase in investor risk appetites.

Looking at this differently, the iShares 7-10 Year Treasury ETF (NYSEARCA:IEF) is actually UP +1% over this same time period. If investors were eager to take on more risk since early October, you would expect the IEF to be DOWN, potentially sharply, and certainly not up.

While an argument could be made that 10-Year Treasury Yields have remained low due to Operation Twist that was launched by the Fed the previous day on October 3, this raises a different question altogether. If the stated intent of Operation Twist was to lower Treasury yields, what has been the point of the program if yields are incrementally higher several months later? The answer to this question is a topic for another day.

Euro Currency

The Euro currency has recently traded with a very high correlation to the S&P 500 Index. This implies that a strengthening Euro currency reflects an increasing risk tolerance from investors moving capital from safe haven assets in the U.S. toward opportunites abroad. Thus, one would expect the Euro to be HIGHER over the last several months. On October 4, the Euro (NYSEARCA:FXE) was trading at 1.334 versus the U.S. dollar (NYSEARCA:UUP). But barring a sharp snapback in October, the Euro currency has continued to drift steadily LOWER ever since. By Friday, the Euro was trading near fresh one-year lows at 1.268 versus the U.S. dollar. Therefore, the stock market rally since early October is not being driven by increased investor optimism about the situation in Europe, as it appears that market participants if anything are increasingly pessimistic.

Italian 10-Year Government Bond Yields

The crisis in the Euro Zone is spread across a variety of countries. And periphery members such as Greece, Portugal and Ireland still warrant close attention. Spain and France are also major sovereigns that are particularly important to watch. But the one country that is looming as the largest present danger is Italy. It is the third largest bond market in the world at roughly $1.5 trillion, so any calamity in Italy could quickly lead to a global financial contagion that would make the Lehman episode pale in comparison. On October 4, Italian 10-Year Government Bond Yields were trading at 5.49%. While not great, this level was still manageable at under 6%. But on Friday, Italian 10-Year Government Bond Yields closed at 6.64% after touching as high as 7.16% to start the week. These yields are now well ABOVE 6% and are unsustainable. This is particularly worrisome with several major sovereign debt refinancings looming for Italy in the coming weeks.

U.S. Economy

The U.S. economy has improved considerably since early October. This is a positive and important development in support of the stock market that should be noted. Several aspects of this recent strength and how it is being viewed raise concerns, however.

First is the notion of "decoupling", which is the idea that the U.S. economy can sustain its improvement regardless of what happens in Europe. Frankly, the idea that the U.S. economy can decouple from Europe is nonsense. The same "decoupling" argument was widely discussed in regards to Emerging Markets in the months leading up to the Lehman crisis in 2008, and we all know how that worked out. We operate in an integrated globalized economy, and Europe is a major source of demand for the U.S. economy. Thus, if Europe falls into crisis or even recession, it will be a major drag on growth here in the United States that could potentially topple us back into recession as well.

Another is the issue of accelerated depreciation. A key element of recent fiscal stimulus efforts was the opportunity for businesses to apply 100% bonus depreciation to new assets that were purchased and put into place by the end of 2011. This represented a major incentive for businesses to bring forward purchases into 2011 in order to capitalize on this benefit. This raises an important issue. Accelerated depreciation was likely a primary driver of the stronger U.S. economic data in the fourth quarter of 2011. And since purchases were brought forward from 2012 and beyond, we are likely to see a comparable drag on growth starting in the current first quarter of 2012. And such signs of renewed economic weakness in the U.S. would be a troubling development for the stock market.

So if many of the above signals are generally unsupportive of the stock rally that we've seen since early October, and those that have been supportive are dubious, what then has been the primary driver? The answer: repeated doses of morphine like monetary stimulus to relax the market into a complacent high. Examining a stock market chart going back to the end of QE2 on June 30, 2011, virtually every major market reversal to the upside can be explained by the injection of monetary stimulus.

Thus, the performance of the stock market can be boiled down to the relationship between two key opposing forces. On one side is the unsettling reality of the problems that continue to plague the global financial system and threaten to spark another major market crisis at any moment in time. On the other side is the sedated hope that as long as a steady flow of monetary stimulus is being pumped into the markets that everything is all right. This relationship has been a back and forth tug of war since the end of QE2 in June, with the forces of "hope" currently outweighing "reality" since the European Central Bank carried out nearly 500 billion Euros worth of 3-year bank loans back in late December. And these upside "hope" forces received an added boost this past week when China joined the stimulus brigade by announcing that they would be encouraging housing and pension funds to invest in capital markets.

So as long as the volume of stimulus flowing into the markets provides enough "hope" to more than offset the crude underlying "reality" that many of the underlying problems dogging the financial system continue to get worse, stocks are likely to continue rising. But such a stimulus driven advance comes with considerable risks. A great deal of monetary support has been provided at this point to maintain the stock market at these levels. If the underlying problems continue to get worse, the forces of "reality" are likely to eventually overwhelm any remaining amount of stimulus left to be pumped into the system. In other words, a day of reckoning likely lies ahead, and the higher the market is artificially inflated by stimulus, the more dramatic the ultimate decline. The catalyst event if any that will finally push reality to drown out hope remains to be seen, but it is a risk that must be monitored closely as we make our way forward into 2012.

A prudent strategy in such an environment is to have a balanced perspective and keep hedges in place. Maintaining an allocation to stocks is certainly warranted given that global central banks remain steadfast in providing whatever monetary support is necessary to thwart a crisis outbreak. In order to manage risk within this equity allocation, it is worthwhile to focus exposures on companies that can participate to the upside but are also conditioned to hold up well if a crisis event were to occur. This includes selected names in the Consumer Staples (NYSEARCA:XLP) and Utilities (NYSEARCA:XLU) sectors such as JM Smuckers (NYSE:SJM), Atmos Energy (NYSE:ATO) and WGL Holdings (NYSE:WGL). Selected names in more cyclical sectors are also worth consideration in this regard including economically inferior goods provider Family Dollar (NYSE:FDO), which is worth a closer look following its recent pullback, and discount fast food retailer McDonald's (NYSE:MCD), which warrants close consideration on any sharp declines.

Beyond the stock market, both Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) are likely to benefit from any further aggressive monetary policy actions while also being suited to provide downside protection if a crisis event were to occur. The same can be said of U.S. Treasury Inflation Protected Securities (NYSEARCA:TIP) and Agency MBS (NYSEARCA:MBB), the latter of which is the likely focus of any pending QE3 stimulus program from the Fed in the coming months. Utilities preferred stocks and exchange traded debt securities such as Entergy Louisiana 5.875 (NYSE:ELA) are also worth consideration at the right price points. Lastly, Long-Term U.S. Treasuries (NYSEARCA:TLT) are also worth consideration for those that are seeking a safer way to establish what is effectively a short position against the U.S. stock market.

The New Year is off to a good start for the stock market. But the economy and the global financial system still have a long way to go before it's out of the woods. And in the end, the only way out may ultimately be a path that proves to be painful for stocks. As a result, it remains worthwhile to stay closely tuned as events unfold in the coming days and weeks.

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.

Disclosure: I am long XLU, SJM, ATO, WGL, FDO, GLD, SLV, TIP, MBB, ELA, TLT.