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The Real Debate: Is the Stock Market Due a Correction or Collapse?

Posted
10/4/2012 3:15:00 PM
By: Martin Tillier
Referenced Stocks:BA;GE;GLD;GOOG;ITB;SLY;VXX

By Martin Tillier

There is a huge, and important, debate going on in the U.S. right now. No, I am not talking about the series of talking point swapping sessions that Mitt Romney and Barak Obama embarked on this week. I am more interested in whether the market is due, or overdue, a correction, or even a collapse.  One year ago, on October 4th 2011, the S&P 500 closed at 1074.77. At the time of writing it is at 1461.18, an increase of 35.95% in a year. Even with the now traditional swoon in May, the index is up around 16% year to date from the 2011 close of 1257.60. It is hard to get away from the feeling that the move up is overdone, but it may help to compare the bullish and bearish cases.

Issue

Bull

Bear

The Economy

We are seeing a gradual recovery from a serious recession. It is reasonable to expect this to continue and accelerate. The housing market is showing signs of recovery.

Unemployment is still over 8%. GDP is growing, but at a snail’s pace. Job creation cannot even cover additions to the workforce. Major indicators are beginning to trend downwards.

The Fed

The Fed is offering the ultimate put. Indefinite QE3 will leave the market awash with cash which must go somewhere.

The Fed is creating a bubble. If the events of 2007-2009 taught us one thing, it is that bubbles burst.

Europe

The recent shift to accommodative policy by the ECB will give European nations the time to recover. The commitment to the Euro remains strong.

The ECB is merely putting a band-aid on a gaping wound. Whatever the level of commitment, the Euro is unsustainable. The inevitable collapse will plunge the world into another recession.

Politics

Whoever wins in November, we will have some degree of certainty. Both candidates are focused on growth. No President or congress will allow us to fall off the fiscal cliff.

An Obama win is looking likely, offering four more years of the same policies. The markets generally prefer Republicans. Politics is still intensely partisan and the fiscal cliff is looming.

Corporate Profits

Corporate earnings are what count, and they are at near record levels. In an increasingly globalized economy, emerging market growth will drive further gains. As Europe recovers, global growth will accelerate (see Europe ).

Corporate earnings have stopped growing. Productivity gains have already been maxed out. Most analysts have issued downward revisions to their year-end forecasts. China’s growth is slowing. A European recession will have devastating effects (see Europe ).

I guess when all is said and done you pays your money and you takes your chance, so the next question is, where do you pay your money?

If the bullish case is more convincing to you, then large, multi-national companies such as General Electric (GE), Google (GOOG) and Boeing (BA) are well-positioned to benefit from global growth. If the recovery does begin to accelerate, then this year’s gains in small caps, as represented by the SPDR S&P 600 Small Cap ETF (SLY) will look puny compared to what is to come, given the sector’s tendency to outperform in boom times. The recovery in housing will be key, so an investment in the homebuilding sector via the iShares Dow Jones U.S. Home Construction ETF (ITB) or something similar would make sense.

If, on the other hand, you are more inclined to the bearish case, there are other options, but the choices are less obvious.  A relatively small investment in the VIX, by way of the iPath S&P 500 VIX Short Term Futures ETN (VXX) would pay off in a big way in the event of collapse. Even at current elevated levels, gold, whether through physical holdings or through the SPDR Gold Trust ETF (GLD) will benefit from any slow down or correction. I would not recommend leveraged bear ETFs for most investors, however. These are useful as short term trading instruments, but are designed to provide daily protection, not long term returns. If you believe a correction, rather than collapse, is imminent, then simply taking some money off the table to be deployed after a 10% or so drop is still the best way to play it.

If anybody is interested in my take on the debate, I believe one factor outweighs everything else in the coming months. Twenty years in the Foreign Exchange market taught me that taking on Central Banks was usually a losing proposition. While the ECB and Fed adding liquidity may have undesirable long-term consequences, it should serve to slow any downward momentum. I am prepared to ride on the tiger’s back for a while longer.