Speaking of “feeling better”, the market’s recent upturn seems driven mostly by improving sentiment. True, as we noted in the economic Insight, recent economic data has been less negative if not outright positive, but we continue to question the sustainability of the most recent stock market rally.

The early September shift in sentiment from decidedly downbeat to a tentatively positive tone has put the bulls in charge for the moment. As the above chart shows, US large-cap (Russell 1000, white), small-cap (Russell 2000, green) and foreign stocks (EAFE, red) have rallied handily in recent days.  The recent performance of stocks in the financial sector has also offered encouragement; we expect that financials will need to participate for any stock market rally to stick. The correlation between financial stocks and the market as a whole has been extremely high since the market bottomed March 6, 2009 (about 79% R-squared); while it’s far from clear sailing we’re considering the possibility that the post-crash low-water mark was Goldman’s appearance before Congress. The recently proposed Basel III regulations aren’t nearly as onerous as they might’ve been (we’ll address in a separate analysis whether we believe that to be a good thing or not) so some of the regulatory uncertainty has been removed. Of course implementation of the US Financial Regulatory Reform legislation remains and obviously few if any financial companies were unscathed by the market and economic implosion or will remain unimpacted by the economic and regulatory environment going forward, but the worst might be behind the sector from a stock performance perspective.

A fly in the proverbial ointment, however, is that trading volume trends have not confirmed the rally.  Trading volume is considered a measure by which to judge the vigor of a market move, and unfortunately for the bullish set volume has steadily declined since earlier this year. The relatively low volume seen on the equity markets also begs a question about which market participants are driving the market action. To update a research piece we wrote earlier this year (“Who’s Buying Stocks, 1/14/10), we don’t exactly know who’s driving but we know who it’s not – individual investors buying stocks through mutual funds.  Stock mutual funds have seen outflows or negligible inflows for some time; by contrast, mutual funds investing in bonds have seen consistent and large inflows since early 2009.

One of the sources of those bond fund purchases has been, we suspect, investors seeking a relatively safe way to improve the paltry yield they’re receiving on their deposit account or money market fund. If true this trend might be considered an unintended consequence of the Fed’s ultra-low interest rate policy, inasmuch that the Fed undoubtedly hoped (expected?) that investors would use that cash to pursue capital appreciation through stocks not higher income through bonds.

Bond markets have been a very interesting venue in their own right of late, with much ink and pixels spilled over the continued decline in long-term interest rates. We plan to consider that subject in a later research piece but suffice it to say that unless the US following Japan’s lead into a multi-year deflation, a sub-3% yield on the 10-year US Treasury Note is unjustifiably low.  Interestingly, while risk aversion may be leading US and global investors to buy US Treasuries, the yield spread between Treasuries and the highest risk bonds – aka “junk” – have contracted sharply since early August, even in the face of substantial issuance.  It remains to be seen whether risk aversion or risk seeking will win the day in bond-land.

TOP: US Treasury yields (orange & green) and “B”-rated corporate bond yields (yellow & red), 8/17 & 9/17, basis points

BOTTOM: Change in US Treasury yields (blue) and “B”-rated corporate bonds yields (orange), 8/17 to 9/17, basis points

There’s been a clear trend towards equity investors seeking out income too, an understandable urge in an environment of low bond and money market yields and questionable stock appreciation potential.  As we mentioned in August’s Harmonic Notes, we expect that dividends will contribute a substantial portion of stock returns for some time to come. In response we’ve executed a shift towards dividend-weighted and dividend-paying ETFs in many of our private clients’ portfolios.

While it obviously doesn’t generate income, gold has also been the recipient of much attention.  Given its historical role as a hedge against uncertainty it’s perhaps the ultimate asset for risk adverse investors.  The price of gold recently reached all-time nominal highs after easing during July.  Energy commodity prices, more leveraged to anticipated economic activity than are precious metals, have been more volatile.

In summary, here’s where we think the stock markets are:

• In a rally that began September 1, 2010…
• Inside a correction that began April 26, 2010…
• Inside a cyclical bull market that began March 2009…
• Inside a secular bear market that began in March 2000.

HAT TIP: Ritholtz.com

We wrote in our 2Q09 client letter that we expected the stock market advance to be less explosive than after previous recessions because the economic recovery would be quite muted. It’s fair to say that we grossly underestimated the fervor for speculation when money’s cheap and the government has virtually assured a taxpayer-funded backstop for bankers and investors who get themselves in trouble. In our defense, though, we got the second half of that assertion correct. The consensus has joined Harmonic in questioning the strength of the economic recovery and consequently the reasonableness of stock prices that rose 80%+ from their March 2009 low.

As the economic problems in the Eurozone revealed themselves and domestic economic indicators showed slowing growth, the US equity markets began to tumble April 27^th 2010. They caught themselves in early July after paring about 17% from their value; for the quarter the S&P500 was down -11.86%. The “sharp sudden break downward” we forecast in our 1Q10 client letter and many other writings and conversations, at long last arrived.

Summer often means a lower level of trading volume, which coupled with the renewed economic uncertainty to contribute to a negative spiral.  Since when trading slows less effort is required to move the market one direction or another, the markets have become exceptionally volatile.  The S&P500 rose or fell 1% or more an extraordinary 30 of 66 trading days during the second quarter. Many investors, including yours truly, are uncomfortable committing capital in such wobbly times, which may explain the news reports of higher-than-normal cash balances that seem to be “sitting on the sidelines”. 

Most companies have reported their second quarter earnings over the past month or so, with a larger than normal percentage (76%) beating analysts’ estimates. However, the reaction to their success has been muted, as analysts question the sustainability of the previous earnings growth in the obviously slowing economic environment.

S&P500 EPS actual (white) vs estimated (orange)

In the short-term we’re concerned about the market’s ability to hold onto gains garnered as stocks found their footing in July after punishing May and June performance. Focus has shifted off the aforementioned solid earnings and back onto the economic and global issues, many of which compound the pessimism. Further, the calendar has now moved into a period of historically poor seasonal performance, which we fear will be exacerbated by a brutal mid-term election season.  The markets dislike uncertainty, and we seem to have little but that at the moment.

S&P500 monthly performance in mid-term election years since 1970;

note negative averages July-Sept

We think it’s likely that the market “trades sideways” with higher than normal volatility for the next several years, which suggests that investors should become more tactical in their approach rather than pursuing a buy-and-hold strategy.  Also, in an environment of low economic growth and the ever-present specter of a deflationary spiral, low bond yields and uninspiring capital appreciation of stocks suggests that income will return to the fore as a driver of investor returns.