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Beginning at least four summers ago, this column suggested that "investors probably shouldn't wish for the circumstances under which the Fed would start easing" (Streetwise, Aug. 6, 2007).
The intervening years have provided material for scores of books and stacks of doctoral theses, and at least one pretty good made-for-cable movie (Too Big To Fail), about the post-housing-bubble financial crisis. But nothing has changed that fundamental point from four years ago, that the Fed comes to the rescue only when the economy or the financial system finds itself in an unfortunate place, and when the stock market has begun pricing in a pretty lousy outlook.
And here we are again, with troubling economic data prompting the clichéd debate about whether "bad news" can be transmogrified into "good news" by the magic of investor wishfulness and central-bank alchemy.
Friday's 2.5% drop in the Standard & Poor's 500, coming after a nifty rally in the latter half of August, proved that the stock market is not insulated from genuine recessionary conditions, even if it has repriced itself for a slower economic metabolism. High on the checklist of things to watch as 2011 winds to a close is how the stock market absorbs what seems to be an inevitable reduction in 2012 corporate-profit forecasts. The market is quite clearly not baking in the prevailing forward earnings numbers, but that's not the same as saying that stocks have fully incorporated a rapid downscaling of earnings prospects for the coming year.
There are a couple of loud arguments being waged in market circles today, perhaps none more raucous than the disagreement between technical market tacticians and strategic fundamental investors.
It has become rather routine, among chart-reading market handicappers, to say that, after this summer's precipitous drop, any rallies are "selling opportunities," and that the risk that the cyclical bull market begun in early 2009 has ended is now significant. The eminent technical analyst Louise Yamada, who now runs her own firm, has been cautious of late and last week wrote this in a client note: "Preservation of capital is our prime concern. We would rather be out of the market wishing we were in than in the market wishing we were out. Portfolio managers with a mandate to stay invested could use hedges to protect portfolios. There are only two losses one can experience: a loss of capital and a loss of opportunity. If we can protect the capital, there will always be another opportunity. The technical indicators currently suggest further risk is possible, notwithstanding even generous rallies."
This is a wholly defensible position, particularly for retail investors, who need not compete with an index and for whom opportunity cost is a purely theoretical rather than manifest expense.
John K. Harris, a market historian who maintains www.wallstreettrafficlight.com, offers that in 14 of the 16 years since 1928 when the market dropped at least 4% from June through August (it fell 7.7% in that span this year), September was a losing month. Whether the economy was in recession, a major topic of debate today, didn't matter in terms of September's market performance.
The recent weeks' rally has brought the market back to a negligible loss for the year, and at the year's high-water mark the average forecasts of the vocationally bullish brokerage-house strategists had just about been attained. Do we need a louder bell to ring to do some selling?
Maybe not, though it remains true that stocks don't "need" to decline from here to price in a soft economic course. Consider that the S&P 500 closed Friday at 1173, a level it first attained in mid-1998. At that time, U.S. gross domestic product was running at about $10.2 trillion. Today it is approaching $14 trillion.
Fundamental investors argue that stocks aren't expensive relative to corporate earnings or most other measures of valuation. But, as Jeff deGraaf of Renaissance Macro Research points out, valuation isn't a particularly helpful guide for timing the market at times when the credit markets are weakening, as they have been lately. This observation places the credit backdrop as a key market-divining clue.
Late summer is a time when hedge-fund desks, staffed by more junior traders, are empowered to curtail risk but not to take on more, even if the markets present such opportunities. So, after Labor Day, let's watch to see what the returning senior portfolio managers do. There are plenty of risks out there, and reasons to think the market might go back to its recent lows. But it is also too soon to declare that the market's highs for the year have been witnessed.
Comments? E-mail: michael.santoli@barrons.com
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