The Weekly Report: On The Rally

27 February 2012


After the meltdown in 2008, subsequent crash in 2009 and the extreme volatility of 2011, many investors are extremely wary of investing in U.S. equities.

However, the S&P 500 is up 6% since January and seems poised to continue upward in 2012 – but as usual, probably not in a straight line.

What’s behind this bull-run? And does the bull have legs?

S&P 500 performance since 2007, with U.S. recessionary period in grey

The S&P 500 has had a very crazy ride since the beginning of the global financial crisis in the summer of 2007, and is still down 6.6% from that period. Volatility has become the norm, and at three points in the last 5 years, the Volatility Index futures contract (VIX), (an indicator of perceived volatility going forward), has spiked more than 200% in less than a week. In fact, the VIX reached a multi-decade high of $80 after Lehman’s default in 2008.

S&P 500 (orange) versus Volatility Index futures (blue) since 2007, with U.S. recessionary period in grey

Most recently, we saw a spike in volatility from June through August 2011, when the U.S. Congress and President were at loggerheads over debt limits, and Greece’s fiscal crisis threatened to overflow into the rest of Europe yet again. Additionally, economic data still showed a somewhat wobbly recovery, adding to a general miasma of uncertainty.

Fast forward six months, and things seem quite different. The U.S. and global economy is still tenuous, but there is a clearer trend of improvement across most economic data. Corporate profits and cash reserves are very high. Unemployment is decreasing, and new jobs are being created. As a matter of fact, government payrolls are shrinking, weighing down the job creation data and boosting unemployment numbers. Mergers and acquisitions are picking up, as well as IPOs. More and more stocks are crossing their 200-day moving average, which is a measure averaging the preceding 200 closing prices and is widely considered a sign of medium to long term bullish momentum.

Europe’s situation is still quite murky, but investors are now increasingly operating under the assumption that Greece will either default or leave the Euro, and it is becoming increasingly clear that the E.U. will take steps to minimize the fallout and mitigate a large part of contagion risk. This does not mean that the markets will shrug off a Greek default, but rather that the reaction to it may not be as drastic (or long-lived) as if people were considering it a remote possibility.

Outside of macroeconomics, there are other factors that can lead to a continuation of the bull market:valuation, bond yields and fund flows. Valuations in the stock market are low compared to historical averages, both in terms of earnings as well as book value. In fact, Bloomberg recently published an article showing that valuations have not been this low since Richard Nixon was President of the United States in the early 1970s.

Bond yields are at historic lows, leading many income-seeking investors to look at high dividend yield stocks, of which there are many solid options. Once the macroeconomic picture becomes clearer, we can expect many retail and institutional investors who went into bonds or cash during the flight to quality last year, to rotate capital back into equities. Once the reversal of fund flows back into equities bears out, we can expect to see a monster rally above 15%.

Nevertheless, there is still exceptional systemic risk, especially from Europe and recently from crude oil’s surge above $105 per barrel. Europe (especially outside of Germany, the U.K. and the Nordic countries) appears to be in a secular decline, as a combination of structural and demographic factors along with austerity policies, curtails growth prospects. A recession in Europe would affect the U.S. as it is a major export market – but would also affect emerging market countries like China, Russia and Brazil that export substantial volumes of goods to Eurozone countries.

On the other hand, crude oil above $105 means that gasoline prices will increase, and they are already up 10% this year, well ahead of the peak gasoline season of summer, when many American families drive to visit relatives or tourism destinations. Ultimately higher gasoline prices could impact company bottom lines, and also lead to inflation, which in turn could affect interest rates. These could adversely affect equities, and could even lead to a negative return at year end. However, careful selection of stocks, and active portfolio management, can lead to medium term outperformance by getting into the market when there is upside momentum with room to grow, and exiting into cash or bonds when certain risks become overbearing.

Firstline believes that many investors, especially those who either, have an existing U.S. Dollar asset base or are looking to invest in U.S. Dollars in future, could benefit from carefully and selectively examining opportunities in U.S. stocks. At Firstline we can work with you and help identify stocks that fit your risk appetite, and craft a strategy that meets your objectives while managing downside risk.

Michael J. Cooper
Trading & Strategy Consultant

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