The Market: Down, Up, Down

Investing Daily Article of the Week

Stock Market Forecast for Remainder of 2012: Volatility Will Increase

by Jim Fink, Featured Expert, Investing Daily

The three words in the title sum up where I see the stock market going in the short, medium, and long term.

In the very short term, the S&P 500 needs to take a breather, near a 57-month high and having risen 15 percent just since its June 4^th mid-year low. Since 1990, the S&P 500 has been positive the week after September option expiration (this week) only four out of 22 years, or 18 percent of the time.

Commercial hedgers (i.e., the “smart” money) have accumulated a $33 billion net short position in equity index futures, the largest amount since January 2007. Active money managers (i.e., the “dumb” money) are currently 95 percent net long equities, the highest percentage in more than 18 months and one of the highest readings in the past six years. Newsletter advisor sentiment (also “dumb”) has now risen to 54.2 percent and is almost 30 percentage points higher than bearish advisor sentiment. Lastly, the number of corporate insiders (another source of “smart” money) selling their company stock is more than six times larger than the number of insiders buying stock, only the fourth time this ratio has risen above 6.0 since early 2010.

According to Jason Goepfert of Sentimentrader.com, whenever sentiment indicators get this lopsided, the stock market almost always stops rising and either stalls or falls over the subsequent 1-3 month period. The key to whether we simply stall or actually fall depends on the S&P 500 and its 20-day moving average (currently around 1,437). If the index falls below the 20-moving average for two consecutive trading days, a 4% to 8% correction over the next 30 days has historically been imminent. Right now, the S&P 500 is at 1,442, which is above the 20-day moving average of 1,437, so no correction yet.

Fundamental deterioration may be the catalyst to get a market correction started. According to Reuters, analysts expect S&P 500 third-quarter earnings to drop 2.2 percent from a year ago – which would mark the first year-over-year decline in three years! In addition, the ratio of companies issuing earnings warnings for Q3 vs. positive earnings outlooks is at 4.3-to-1, which is the most lopsided bearish ratio in 11 years (since the third quarter of 2001).

Part of the reason corporate earnings may disappoint is because consumer and corporate spending is already being curtailed in anticipation of the fiscal cliff scheduled to take effect in January 2013. Another reason to expect weak earnings is the fact that the global economic picture outside of the U.S. continues to darken. Chinese manufacturing output has declined for 11 consecutive months and Eurozone services and manufacturing output has declined for 39 consecutive months. According to David Bianco, Deutsche Bank’s chief U.S. equity strategist, poor third-quarter earnings are likely going to be the catalyst for a 5-percent market correction:

Investors seem to be ignoring weak 3Q EPS, but widespread misses should cause a dip. The next 5%+ S&P 500 price move is likely to be down, but if no dip in October then unlikely to happen by year end.

Goldman Sachs is forecasting a much-steeper 15 percent stock- market correction that will start soon after the November 6^th U.S. presidential election, resulting in the S&P 500 dropping to 1,250 by the end of the year. Hardest hit will be stocks that have already underperformed during the first nine months of the year. In the 23 years since 1980 that the S&P 500 gained ground during the first nine months, underperforming stocks continued underperforming by an average of three percentage points during the fourth quarter. This historical analysis suggests that investors should stick with positive momentum stocks through the end of 2012 and not try to pick bottoms in supposedly “undervalued” stocks.

After the market completes a short-term correction (whether it starts now or waits until after the election), the intermediate term looks bullish for stocks. Let’s not forget that the first two weeks of September were historic – a turning point in the history of economics. Three things happened this month that Morgan Stanley characterizes as a “bazooka blast of monetary support:”

1. The European Central Bank implements Outright Monetary Transactions (OMT), which provide an unlimited commitment to purchase short-term sovereign debt (three-year maturity or less) in order to reduce the borrowing costs of weak Eurozone countries like Spain, Portugal, and Italy and hopefully stave off a government default.
2. China announces $157 billion in new infrastructure spending, which is a quarter of the size of the original and massive 2008 economic stimulus.
3. The U.S. Federal Reserve implements QE Part Infinity, which will print $40 billion each and every month to purchase mortgage-backed securities until the U.S. labor market exhibits “substantial improvement.”

According to equity strategist Don Hays, interest rates are so low and monetary policy is so positive right now that investors have no choice but to invest in stocks and commodities. In fact, looking back through 50 years of market history, whenever financial conditions have been similar to now Hays concludes that:

There’s an 84% chance that stocks will be higher in the next 12 months by an average of 26%.

Over the next two months heading into the U.S. presidential election, however, Hays sees the chance for a 10 percent correction. Also intermediate-term bullish is Bank of America Merrill Lynch, which recently reported that its “Sell-Side Consensus Indictor,” which measures the sentiment of Wall Street equity analysts, is extremely bearish towards equities — recommending only a 44.4 percent portfolio allocation to stocks compared to the long-term average allocation of 60.7 percent. This bearish sentiment represents a 27-year low which, from a contrarian standpoint, is extremely bullish.

Other bullish intermediate-term indicators include:

• After the Federal Reserve announced QE1 and QE2, stocks rallied by an average of 10-15 percent in the six weeks following the announcement. If stocks were to do the same in the six weeks following the Fed’s September 13^th announcement of QE Infinity, the S&P 500 would rise from 1,437 on September 12^th to a level anywhere between 1,580 and 1,652 by October 25^th.
• Stocks have outperformed bonds by 10 percentage points so far in the third quarter, which historically has led to further stock gains in the following quarter 80 percent of the time (second quarter 2012 was one of the exceptions, however).
• The Dow Jones Industrial Average has not experienced a 1-percent decline in 63 days while hovering near a 52-week high. Such strong price momentum at 52-week highs has occurred only 16 times since 1900 and the Dow has been higher six months later all 16 times by an average of 6.0 percent.

According to Morgan Stanley, the best-performing industry sectors during the 12 months of QE1 (Mar. 2009 to Mar. 2010) and the ten months of QE2 (Aug. 2010 to June 2011) were:

• Oil services
• Consumer discretionary
• Industrials
• Materials

It doesn’t surprise me that these industry sectors outperform in times of easy money. Oil and materials are commodities that thrive when the U.S. dollar is debased because they become more affordable to foreigners, which boosts demand. Similarly, consumer discretionary involves big-ticket items that are usually purchased on installment plans, which are much more affordable when loan rates are low.

Long term, all of this money printing simply has to end badly. The result will be domestic c inflation and currency wars with foreign nations that must match U.S. dollar debasement by devaluing their own currencies in order to protect the competitiveness of their export markets. Brazil has severely criticized the Fed’s QE Infinity and threaten to take retaliatory actions. PIMCO’s Mohamed El-Erian went so far as to allege that the Federal Reserve “wishes” to spur inflation in order to reduce the burden of debt and incentivize people to buy things before prices go up further. El-Erian predicts that the Fed’s unprecedented experiment will end up eventually causing a “mess” and investing will become a “difficult minefield” as inflation spirals out of control.

St. Louis Fed President James Bullard warns that QE Infinity could lead to 1970s-style stagflation — “double-digit inflation and double-digit unemployment simultaneously.” Nobel Prize winning economist Joseph Stiglitz has stated that more quantitative easing “won’t work” other than to cause inflation and result in an emerging-markets bubble that is “not going to be good for the world.” Lastly, hedge fund manager Ray Dalio foresees several more years of global deleveraging that could lead to either hyperinflation and/or an economic depression, either of which could result in severe social unrest.

The potential for a severe economic crisis in the future doesn’t appear to be worrying investors yet, thanks to continued euphoria over the short-term boost to asset prices caused by QE Infinity. The S&P 500 Volatility Index (Chicago Options: VIX) is back below 14%, very near the five-year low set on August 17^th. Any hiccup in the financial, economic, or political realm should cause the VIX to soar. A negative stock-market reaction from any unexpected shock will be magnified by the fact that the stock market is overvalued from a historical perspective by somewhere between 15% and 50%.

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