Investors, Be Cautious…What’s Changed and Why?


One of the things that trading room experience teaches you is that an open mind is a wonderful thing. You may formulate an idea based on sound logic and see things play out roughly as expected, but even then, when it does, you have to reassess the situation based on what actually happened. I live in America, a land where freedom of speech is highly valued. I will always defend the right of journalists to speak freely and to freely contradict whatever they wrote just a short time ago. Without that freedom, many column inches would be left blank every day. So, with that in mind, I am going to urge caution over the next few weeks.

I have, on several occasions over the last few weeks, warned against panicking as the budget crisis approaches and suggested viewing any drop in stocks as a buying opportunity. Yesterday it became increasingly obvious that no resolution to the problem was imminent and that a government shutdown of sorts was inevitable. The market’s reaction to that inevitability was, in the grand scheme of things, a big, fat “So what?”

The S&P 500 fell around 10 points, or 0.6%, the Dow was down 128.57 points (0.849%) and the NASDAQ lost only 0.27%. As I write, futures are indicating a higher opening on all major indices this morning. This is hardly the stuff of financial Armageddon. All of the talking heads who were predicting some kind of meltdown are now saying that the lack of a reaction was predictable and understandable, and that, on balance stocks still look cheap.

When all of that is viewed together, the contrarian in me starts to scream a warning.

This distinct lack of concern by investors over the shutdown, while logical in many ways, is worrying to me for three reasons. Firstly, it smells of what Greenspan once called “irrational exuberance”. Secondly, Wall Street not showing any obvious concern about political intransigence and failure does nothing to discourage it in the future. Lastly, it makes “tapering” by the Fed that much more likely.

Regarding the first point, the “storm in a teacup” that I wrote of yesterday would have been understandable, but a general dampness and light breeze in said cup suggests a worrying sense of invincibility amongst traders and investors.

When “groupthink” takes over in any market, taking the opposite position is always profitable at some point, the question is “when?” It may be too soon to actively oppose the general bullish sentiment, but taking some money off the table in anticipation of a snap back may well be wise. A more aggressively bearish stance would, in my opinion, be warranted should we approach the recent highs again.

The second concern requires a healthy dose of cynicism regarding the political process, but given recent history that isn’t hard to acquire. It worries me that, should this impasse continue, and should the market continue to ignore it, then the chances of a timely resolution to the issue are reduced.

As the potentially more devastating debate regarding the Debt Ceiling approaches, politicians could become emboldened in their intransigence, believing that the economy is somehow immune to their dysfunction. An extended dispute over this issue and the possibility of a default by the US would, in these days of global capital shifts, not be ignored.

Even if this view proves to be overly pessimistic, another event will then be likely to put a top on any move up from here. If the Federal Reserve see markets buoyant throughout the political crises and perceives over optimism, they are more likely to start to reduce QE sooner and/or more aggressively. I cannot stress often enough that placing $85 Billion a month in the hands of financial institutions puts a floor on any correction. That money has to go somewhere, so there is natural support for stocks. A gradual reduction in the amount could well have a limited, short term effect followed by a speedy resumption of business as usual, but any hint that the pace of reduction in QE will be faster than anticipated could trigger a serious drop in equities.

There is an irony to this situation. The market has seen things my way and refused to overreact. Because of that, I am now much more cautious than before. I would have preferred a good old fashioned panic. It must be said that US stocks do still look fairly cheap at current values when compared to any alternative, but that valuation contains some assumptions about the future. Most importantly it is assumed that the US economy will continue to grow at an admittedly slow, but steady, pace.

By not sending a signal of concern to Washington, Wall Street has made the derailment of that continued growth more likely. Even if the political types see sense, any relief rally would be capped by the ensuing reduction in monetary stimulus. However it pans out, a significantly higher stock market come the end of the year would be a surprise.

Of course, over decades stocks will still be the best investment and if that is your time horizon then watching only sports, sit-coms and reality shows over the next few months, and ignoring the news is your best bet. For those who look shorter term, however, the limited reaction to a Government shutdown suggests that a “mini-bubble” is forming, and caution is best advised.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: News Headlines , US Markets , Economy , Stocks

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Martin Tillier

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