Be cautious despite signs of market rally
Use upside momentum to hedge risks
Global stock markets have been on fire lately, rebounding strongly off their May lows. Perhaps they’ve caught Olympic fever. But before investors think they’ve missed something and start buying, it’s worth stepping back to take a broader look at the underlying motivation driving the current rally as well as some of the near-term risks.
To begin, we think John Hussman, of Hussman Funds, quite eloquently summed up the market in his most recent newsletter: “The key question — in view of extreme credit market strains in Europe, and accelerating economic deterioration in the U.S. — is why the S&P 500 continues to trade within a few per cent of its April bull market high. The answer is simple: Investors are scared to death of missing the widely anticipated market advance that they expect to follow a widely anticipated third round of quantitative easing.”
We can’t blame investors for positioning themselves to participate in a central bank stimulus rally because such moves can be quite rewarding, as evidenced by the positive market action in the past two years after policy announcements.
The problem, however, is that the S&P 500’s recent rally has brought it to a level that more than fully factors in the effects of a QE3 program, which at this point hasn’t even been announced by the U.S. Federal Reserve. As a result, investors seem to be exhibiting the classic behavioural flaw of ”buying on rumour” while exposing themselves to danger when the eventual selling comes “on fact.”
What troubles us is just how aggressively the market’s been responding to rumours and speculation about how the mess in Europe is going to be dealt with. For example, just this past Friday the S&P 500 rallied nearly 2% strictly on speculation that the European Central Bank is meeting with the Bundesbank to convince it to do more bond buying. But more bond buying will not resolve the situation in Europe. It’s simply putting a Band-aid on a gaping wound.
Just how big is this wound? Well, it has now spread to Spain, the 12th-largest economy in the world, fifth-largest in Europe and fourth-largest in the eurozone, according to Wikipedia. Spain’s unemployment rate hit a whopping 24.6% in the second quarter, which means there are more than 5.7 million people looking for work. Over half of those under the age of 25 who are able to work are unemployed.
On top of that, the coun- try’s economy contracted 0.4% in Q2, and is down 1% over last year’s levels, its central bank says.
Investors have reacted by selling Spanish 10-year bonds, pushing the yield to a record high of 7.5%, while the Spanish equity market has sold off by nearly 30% this year. These factors must be considered before buying on the news that the ECB will be buying Spanish bonds.
But it’s not just the eurozone that’s in trouble. The U.S. economy is clearly slowing judging by its secondquarter annualized GDP growth rate of only 1.5%, which is down from the 2% posted in the first quarter. U.S. corporate earnings have also been showing signs of weakening, which is problematic as it tends to be a great proxy for how the country’s economy is performing. The second-quarter earnings beat rate has come in at a respectable 69%, but the revenue beat rate is only 40%, the lowest it’s been since the first quarter of 2009.
Investors are scared to death of missing the widely anticipated market advance
As a result, the number of downward forward revisions from sell-side analysts has accelerated. In the broader S&P 1500, analysts have reduced their forward projections on 792 companies and raised them for only 323, reports Bespoke Investment Group. Consequently, analysts now expect revenue growth of only 1.0% to 1.5% in the third quarter.
We can’t blame the analysts for being bearish, since U.S. companies themselves are also quite negative on their near-term outlooks. Based on 54 pre-announcements, the negative-to-positive ratio for the third quarter stands at five to one, the most negative it’s been in 11 years, Thompson Reuters Data says.
In conclusion, all the recent buying in the equity markets just doesn’t make sense to us given the weakening global economic backdrop and the escalating European debt crisis. While there may still be some upside momentum left in this rally, we would exercise caution before jumping in with both feet based on fears of missing out. Rather, we recommend investors take advantage of this current momentum in the market to at least hedge some of the aforementioned market risks.