In my view, the markets are in the early stages of a significant rally that could last for several months. Although the economy may grapple with debt-strapped consumers and other factors that led to last year’s collapse, significant market rallies have historically taken place during times of economic rebuilding. While I remain somewhat cautious about the longer term outlook because of lingering problems from the build-up of debt and the potential for inflation, I believe the markets can move significantly higher as economic conditions and investor expectations improve in the next few months. Here are some specific reasons for my optimism:
Massive government intervention seems to be working
The problems that led to last year’s economic and financial collapse were significant, but no one should underestimate the power of the massive governmental interventions deployed to reignite growth around the world. Monetary stimulus supposedly acts with a lag of about 12 months. Throughout much of 2008, the Federal Reserve undertook unprecedented efforts to jump-start the economy, and in the fall, countries around the world followed. While the continuing problems within the U.S. and foreign financial systems have complicated things, the beginning signs of stabilization in the United States — for instance, U.S. home sales rising in April — and overseas suggest the stimulus efforts are having their intended effect.
Expectations are being exceeded, which typically leads to market gains
Having spent months pricing in the expectation of a severe and prolonged recession, the markets should move higher if the economy beats expectations. Improved housing starts, rising consumer and business confidence, increased business activity, and rising domestic and international equity markets themselves all suggest that U.S. and international economies are moving toward recovery. If this recovery is delayed or somehow stalls, these statistics should provide some warning. For now, though, the evidence suggests an economic recovery will emerge later this year, and that should help the equity markets move higher.
Risk taking bodes well for the markets and the economy
Investors are again taking more risk, as evidenced by the stronger performance of emerging markets, leading market sectors such as basic materials and consumer discretionary goods, and even higher-risk corporate bonds. This willingness by investors to take more risk suggests two reasons to expect support for higher equity prices.
First, as renewed confidence filters into the markets, more money flows in from the sidelines. Although confidence has obviously improved, we’re still hearing broad skepticism about this rally from clients and other investment professionals. This skepticism suggests there is still quite a bit of money on the sidelines that can drive prices higher.
Second, investor actions are typically a good indicator of consumer and business confidence. When investors take more risk, consumers and businesses also tend to spend more freely. Credit availability may hamper some spenders, but the spending that fears about the economy suppressed should now begin to flow. As an indicator of both market demand and economic prospects, increasing risk tolerance points to further market gains.
Trend reversals tend to feed on themselves
Economic and market trends often go to extremes before they reverse. Thus, when a reversal comes, the “overshoot” helps to maintain and propel the new trend. In the current cycle, just-in-time inventory management has allowed companies to respond quickly to falling sales, but those techniques have also reduced companies’ abilities to forecast customer demand. With reduced visibility, the intense inventory reductions this year may take inventories too low, and so if demand comes back faster than expected, the rebuilding of inventory may significantly boost growth during the early stages of recovery.
Investment markets embody a similar dynamic. Investors who sell their holdings or allow their portfolios to become extremely defensive during bear markets tend to get caught short when rallies begin. Surprised by the power of initial rallies, investors often wait for a pullback to buy at lower prices. Instead, the market pulls back little, if at all, and investors scramble to catch up with the market. In my view, investors’ broad skepticism of recovery and a reluctance to invest after a strong rally are symptomatic of the early stages of a new bull market. This provides a reserve of buying power that helps propel markets higher as buyers become convinced a new bull market has begun.
Note: McCain’s opinions reflect those of the investment-strategy group at Key Private Bank.
Follow Blog War on the future of the stock market:
- Bruce McCain, 6/1: This Bull Market Has Legs
- Michael Markowski, 6/2: The End of This Bear Market Rally Is Near
- Bruce McCain, 6/3: Actually, the Bear Market Might Be Ending
- Michael Markowski, 6/4: This Bear Market Still Has Claws
