A look at key forces that have had and will continue to have an impact on the market.
The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
By Doug Roberts
NEW YORK -- During November we experienced a huge interruption in the rally begun in October. However, the rally in the equity markets around the world and in risk assets in general resumed, as central bank coordination was announced.
Will the rally continue or will a downward spiral start again? Are we perhaps in a broad, extended trading range? This has implications for the financial markets in both the short and long terms and is the subject of this month's commentary. A Late Halloween in 2011 Normally Halloween, the scariest time of year, comes at the end of October. If we look at the financial markets during the month of November, it appears that Halloween arrived late this year.
The markets experienced minor volatility for the first half of the month. Markets then began to drop quite substantially as the European debt crisis appeared to spiral out of control. The Thanksgiving holiday rally appeared to be turning into a real turkey with a drop of almost 10%. Central Bank Intervention Many pundits were saying that the central banks and the governments were powerless to stop the downward spiral. Bearish sentiment was rising to elevated levels. Then, just as it appeared the markets were going to crash, coordinated central bank intervention was announced.
The Federal Reserve, the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Canada and the Bank of Japan announced "coordinated actions to enhance their capacity to provide liquidity to the global financial system. ... These central banks have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points." Separately, the Bank of China eased as well.
After the announcement on November 30, the markets proceeded to rally by almost 5% across the board. The question becomes whether the rally will continue. Another Parallel to 2007 We have mentioned several similarities between the equity markets of 2011 and 2007:
Both seemed to bottom in the middle of August. There was a fear that the financial world was going to collapse. In 2007, this was due to the implosion of the sub-prime mortgage market. In 2011, it was due to the European financial crisis.
After the bottom occurred in 2007, there was a strong rally that recovered all the lost ground, thus ending the year on a positive note. This seems to be very similar to the rally that we are currently experiencing in 2011. We bottomed in August and have experienced a very robust but volatile rally since then.
Market leadership in the latter part of 2007 was also quite different from earlier in the year. Earlier that year, smaller companies in terms of market capitalization were the leaders in performance. After the market bottom, it was the larger companies that assumed the market leadership position. Large technology companies were the best performers. This is very similar to our current situation in 2011. We are now experiencing another striking similarity to 2007. Similar coordinated central bank intervention occurred at the end of 2007. This appeared to resolve stress of the sub-prime mortgage crisis, and the financial markets rallied into the end of 2007 and briefly into 2008. Then, the rally fizzled and required additional central bank intervention. The Key to the Markets: Central Bank Neutralization of Threats! Systemic bank uncertainty lay with the sub-prime crisis in 2007 and currently lies with Europe in 2011. There was limited transparency regarding the financial institutions holding this debt. In 2007, this led to a domino effect that spread through all the world's financial markets.
In 2007, the Federal Reserve and other global central banks began to adopt a looser monetary policy in response to the sub-prime mortgage crisis. They assumed that the standard monetary response would be effective in containing the crisis and preventing the domino effect described above.
Initially, it appeared to be working. This is what triggered the rally in the latter half of 2007. Then additional problems, such as the bankruptcy of Lehman Brothers, became difficult to contain using standard monetary policy tools.
Monetary policy will need to be loosened even further, including possibly a massive intervention to at least postpone financial Armageddon to a later date. Nothing will be truly resolved, but the game of "kick the can down the road" can continue. The Lehman Bankruptcy The Lehman Brothers bankruptcy on Sept. 15, 2008 could be called the "tipping point" of the financial crisis. In my earlier commentaries, I mentioned that the biggest danger of Fed policy is that it reacts to a deteriorating economy but does so too slowly. This is what happened in 2007-2008. The Fed began to ease monetarily in response to the financial crisis but at a very slow pace because of inflationary pressures.
As the markets began to deteriorate, the Fed appeared almost powerless to reverse the downturn. The deterioration quickly began to domino across all the world-wide financial markets. This was only stopped when the Fed and the government began to take extraordinary measures.
On the day prior to the Lehman Brothers bankruptcy on Sept. 15, 2008, the S&P 500 closed at 1,251.70. This is very close to where the index is trading as I write this commentary. Thus, all the extraordinary measures by the Fed and the government have only succeeded in keeping the index flat over the last three years. A Trading Range If the Fed had not allowed Lehman Brothers to go bankrupt and had acted more quickly in terms of monetary easing, one can argue that the end result might have been the same with regard to the financial markets, but the trading range would have been much narrower. We would not have had such a severe bear market, but the end result might not have been very different.
We currently seem to be in a trading range on the S&P 500 of 1100-1300. If the Fed makes a mistake like in 2008, the index could drop significantly lower. If it undertakes major stimulus program such as QE3 or if the European Central Bank issues European Bonds, we could challenge the highs experienced this year. However, if the Fed continues on its present limited course of action without making a serious mistake, we may be locked into this volatile but frustrating trading range for the near future.
Any Santa Claus rally that occurs will be in the context of this range. It will truly be a trader's market. Unemployment and Recession The economic situation was much brighter in 2007 than today. The unemployment rate was almost half of what it is today. In general, the situation was looking like a severe recession in 2007, not the dire economic conditions of today.
Recent economic reports indicate a weak expansion, but not a situation in which the country is in recession. As I have mentioned, the improvement has only been marginal at best relative to the fiscal and monetary stimulus and the amount of time that it has taken for this to occur. Although these numbers are still in positive territory, many are still quite uncertain about the future and believe that without further government intervention, we could slip back into a recession.
Any improvement in the economy has been quite limited with only a small segment of the population participating, leading to what we described as "two economies." One has seen a rebound, but the other has not really experienced much improvement.
This has really not borne any resemblance to the "V-Shaped" recovery that many were forecasting. It is much closer to the jagged "U-Shaped" economic recovery that we predicted.
I have said previously that this is quite different from earlier recoveries. In most of those earlier cases, government stimulus merely "primed the pump" until the private sector took over. Now, government remains "the lender and spender of last resort." Threshold of Pain We have seen a familiar pattern in the crisis regarding fiscal and monetary stimulus. As the government institutes some program, we see an economic recovery. Then, when the program ends, the economic figures recede. This is true in cases of spending programs such as infrastructure or tax incentives as well as quantitative easing. The end result is still the same.
The real question becomes the threshold of pain required for the government to institute one of these programs. I have noticed that the level of pain required is lessening as we approach the election year.
This is not unique to the current situation and seems to be following the familiar election-year cycle. Quantitative Easing If the economic situation remains so depressed, why do the financial markets rally? The answer is liquidity. This liquidity has been created by the Federal Reserve along with the other central banks. In addition to the effect on earnings and refinancing mentioned earlier, it also increases the price of risky assets, otherwise known in Wall Street terms as the "Risk Trade."
We saw this last year with the introduction of QE2. Operation Twist seems to be continuing this. Although the financial markets have rebounded from the lows in 2009, quantitative easing has had a relatively minor effect on the real economy. Thus, many people view quantitative easing as merely a benefit for the banks and the wealthy, one which adds significant costs for the average individual. In this environment, there may be substantial resistance to a QE3. Potential Threats There is unrest in the Mideast today, unlike in 2007. The Arab Spring is turning into an Islamic Winter. There is discussion in Egypt about abrogating its current Peace Treaty with Israel. The current military government will not allow this to happen. However, if an Islamic party comes to power in the next election, the possibility of this occurring could increase substantially.
Iran is also continuing with its nuclear program despite U.S. opposition. If it continues on schedule, it is possible that it could pass the point of no return within the year. There are rumors that the Israeli government may be planning a strike on Iran to prevent this.
Thus far, the situation appears to be contained. However, the potential for the outbreak of hostility still remains.
Here in the U.S., there could also be serious problems if the budgets required by the Super Committee are instituted. Many are assuming that Congress and the president will at least resolve this with temporary spending measures. This is by no means certain. The Fed and the Treasury Markets The fear of holding any risky assets has resulted in a flow of funds into Treasury securities. The supply of U.S. dollars is controlled by the Federal Reserve, which can print U.S. dollars at will to satisfy its debt obligations and maintain low interest rates. The value of the U.S. dollar might suffer considerably, and there could be substantial inflation. This may be linked to the current rise in gold prices.
For those who claim that such a scenario could never occur, one must remember that during World War II the United States was able to maintain very low interest rates during a time of severe inflation. However, there were substantial restrictions on trade and commerce. Owning gold was also prohibited. Forecast: 2012 Will Depend Upon Government Stimulus! If there is not a major shock to the global financial system such as the ones described above, the 2011 rally should continue. We should not exceed the spring highs in any case without a government stimulus package.
With regard to 2012, it will depend upon government stimulus. If the Fed acts, we will either be in the trading range or rally higher depending upon the size of the stimulus. Any of the shocks described above could damage the financial system quite substantially. As long as the Fed and the government are able to counteract these threats successfully, the situation may not deteriorate massively.
These threats are significant. If the Fed makes a mistake like 1931 or 1987, serious problems could occur. The United States equity markets are particularly vulnerable, since many of the sources and solutions to these problems are largely outside of our control.
Many of our Twin Foundations(?) strategies have turned positive during the last month. Nevertheless, our U.S. Equity Trend Indicator turned negative during the summer and still remains so, as it did during the end-of-year rally of 2007. It did also keep us out of the market during the carnage of 2008 and 2009. This is something worth considering in designing your investment portfolio.