We anticipated some recovery in the stock market in September, based on the oversold conditions and the extreme pessimism that existed at the end of August, but the strength of the recent rally has been surprising. The S&P 500 returned 8.9% last month. Broad foreign stock ETFs denominated in U.S. dollars gained over 10%. All of the major domestic and foreign indexes have achieved technical price breakouts, which have flipped the intermediate-term stock market trends from down to up. There are ample reasons to maintain a cautious investment posture (discussed below), but the stock market is certainly acting much healthier. Now that the S&P 500 has cleared key resistance at the 1125 level, the next technical objective is 1175, and if that hurdle is overcome, the April highs at 1220 will come into focus (Exhibit 1).
Apart from an excess of pessimism a month ago, what has been driving the rally in stocks? The economic data have been somewhat better in September, but certainly not strong enough to take double-dip recession risks off the table, which the stock market appears to be doing - at least for now. We would feel more confident about the positive signal on the economy implied by firmer stocks if it were accompanied by a significant uptick in the leading economic indicators we track from the Economic Cycle Research Institute.
Unfortunately, those indicators remain deep in negative territory, and according to ECRI, recession risks remain quite elevated. Risks of economic relapse will remain high until we see meaningful private sector job creation, which has been almost totally lacking thus far in the economy recovery. Only 9% of the private sector jobs lost in the recession have been regained. Moreover, the prospect of an income tax increase for anyone making over $250,000 represents a major challenge for the economy in 2011.
Another impetus for the recent rally may be that investors are anticipating more business-friendly government policies as a result of the November 2 elections. It is certainly true that the elections will have a large impact on government policy, but at this stage it is highly unpredictable what those policies will be. The reality is that the stock market will have to deal with major uncertainties surrounding fiscal policy until after the election. One aspect of the elections that is unequivocally bullish is the historical record of strong stock market returns subsequent to mid-term elections. The next three quarters - starting in the 4th quarter of the mid-term election year (which begins today) - historically provide 3 of the 4 biggest quarterly gains over the past 20 election cycles since 1929 (Exhibit 2).
In addition, in the past 17 mid-term elections (since 1942), the stock market has gone up 100% of the time in the 200 days following the election, with an average gain of 18.3% (Exhibit 3).
There are several possible explanations for strong stock market performance following mid-term elections. First is stimulative fiscal policy as the Administration looks ahead to the next Presidential election. With today's trillion dollar deficits, it is hard to imagine fiscal policy becoming more stimulative, although there could be a political compromise to extend upper-income tax cuts or raise the $250,000 income threshold that was arbitrarily selected by the Democrats. Second is an easy monetary policy, which Fed Chairman "Helicopter Ben" has essentially guaranteed. And third is the psychological hope or expectation that the midterm election could bring about positive change.
Unfortunately, the predominant factor driving the recent stock market rally may be the anticipation of more monetary inflation courtesy of the Fed. Just when we thought the monetary spigots could not be opened any wider, the Federal Reserve in late August began to lay the groundwork for another round of quantitative easing ("QE2") - the purchase of assets with newly printed money. The message from Bernanke in his August 27 Jackson Hole speech was that the Fed was prepared to provide additional "monetary accommodation" (i.e. money printing), if the economic outlook were to deteriorate further. The Fed upped the ante in its September 22 monetary policy statement by stating that inflation was below levels it considered consistent with its "mandate". In essence, the Fed told us that QE2 is no longer dependent upon persistent economic weakness. The Fed now has an overt bias toward easing and is openly targeting higher inflation, despite the fact the commodity prices, particularly precious metals and agricultural prices, have been soaring, and the U.S. dollar index has dropped 5% since Bernanke's Jackson Hole speech.
Our view has been that Fed policy is misguided, and the last thing the economy needs right now is more monetary accommodation. We print money to buy our own Treasuries to keep rates low, enabling the upward spiral in government debt, while devaluing the currency. The zero percent interest rate policy exacts a huge penalty in foregone interest income from American savers and retirees. Against this backdrop, it is no wonder gold is trading at record highs!
But we have to deal with circumstances as they are, not as we would prefer them to be. The objective conclusion to draw from the shift in the Fed's posture toward further monetary easing is to be more bullish on stocks (especially emerging markets) and commodities, and more bearish on the dollar and bonds. QE2 may postpone the inevitable bear market in bonds, but is only a matter of time before the Fed loses its ability to manipulate the Treasury bond market. Notwithstanding the assurance of monetary accommodation from the Fed and the improved technical condition of the stock market, we are going to be patient about taking on more risk in our portfolios. The recent breakout and strong technical action of the market probably means that the path of least resistance will continue to be higher in the short term. Buying dips has been working for traders, and that may well continue for awhile.
We may end up being proven wrong, but for now we are still operating from the assumption that the April highs (1220 on the S&P 500) define the maximum upside for the balance of 2010, and we would not be surprised to see another test of lows (currently 1010). Based on this premise, and given that the S&P 500 is now 6% from the top of this range and 12% from the bottom, the risk/reward does not appear favorable for adding stock exposure. If the economic outlook starts to improve, stocks have more upside, but it is too early to make that bet with confidence. Stay tuned.
In setting our somewhat cautious investment course, we are mindful of the elephant in the room, namely the upward spiral in U.S. government debt and unfunded entitlement promises, which represent the greatest longer-term risk for the economy, markets and indeed our society as a whole. We have no confidence in the ability of our government to deal seriously and proactively with this problem. Perhaps we will be pleasantly surprised by the changes in the political climate following the mid-terms, but we are not counting on it. Until the markets refuse to finance irresponsible government spending and indebtedness, and something bad happens to the dollar, interest rates, or inflation, our guess is that politicians and a complacent public won't have the will to act.
As a result, it seems logical to expect a continuation of a sharply rising government debt-to-GDP ratio. Gold also achieved a bullish breakout in September, surpassing prior all-time highs at $1260. Gold closed yesterday at $1307. There has been a remarkable lack of volatility in the $125 gold rally since the beginning of August. Gold has steadily moved higher without any meaningful pullback. Gold has not had more than a 1% correction in over two months. With governments around the world in competition to lower the value of their currencies through various policies such as quantitative easing or foreign exchange market intervention, gold is increasingly seen by private investors as well as central banks (who are net buyers of gold this year for the first time since 1988) as an alternative to paper money and a more attractive store of value.
With the gold price reaching a new nominal all-time high this month, it is worth putting the current price in context. When adjusted for inflation, gold remains well below its $850 nominal high posted in 1980. Adjusted for inflation, the current price of gold is 36% below the peak price of more than $2,000 per ounce (2010 dollars) in January of 1980 (Exhibit 4).
The government debt picture in 1980 wasn't anything close to where it is today, so a $2,000 price is certainly not an unrealistic target over the next five years. However, investors should be cautioned that the path to higher prices will be nothing like the steady ascent of the past two months. We suspect that the gold bull market is moving to a phase characterized by much higher volatility and increasing participation by the public. For example, from whatever peak if reached in the fourth quarter ($1400?), it would not be surprising to see gold undergo a multi-month correction/consolidation period where it could drop $250 or more in value, then subsequently rise to new all-time highs. Going forward, we may attempt to address this anticipated volatility by scaling up and down the gold position in our portfolios.
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