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These Aren't Normal Times

Written By Briton Ryle

Posted September 11, 2014

Sentiments on Wall Street seem to be changing. Analysts and fund managers grew decidedly more bearish as summer dragged on, with cash pouring into the more defensive vehicles like U.S. Treasuries on the expectation of a 10 percent-plus correction in equities.

But all of that bearish talk turned bullish once again, and all it took to trigger that change of heart were a sour economic report and a central bank decision. These two cards drawn from the economic deck late last week have changed Wall Street’s hand, forcing traders to play the game differently.

But the draw isn’t over yet. There are two more geopolitical cards to be drawn that could introduce a lot more volatility before this bull run is over. Is your portfolio ready for a continuing bull run on a slippery road?

How Sentiments Change

To understand why Wall Street has recently turned bullish we need to look at why it had turned bearish in the first place. Here are just a few reasons why everyone entered the summer with bleak hopes:

• Three full years without a meaningful correction, dating back to the fall of 2011 when the S&P 500 fell from 1,350 to 1,100 for a loss of 18.5%,

• A string of new all-time monthly highs numbering 18 out of the past 20 months since the start of 2013,

• A string of fabulous job reports which saw new jobs being added at a rate of over 200,000 per month from February to July averaging 239,000 per month,

• The winding down of the Federal Reserve’s QE3 monthly bond buying program, which leaves the door open for interest rate hikes soon after,

• Inflation had been running at the Federal Reserve’s 2% target for four months from April to July.

The expectation was that things had been humming along too well for too long without a cloud in the sky. But with inflation stepping in and the Fed stepping out as it ends its bond purchases, it was believed interest rates would start rising sooner than previously thought, perhaps as early as Q2 of 2015, limiting the upside to equities.

This growing pessimism drew more money into the safety of bonds, as the benchmark 10-Year U.S. Treasury yield fell from 3.05% in January to 2.35% at the end of last month – a plunge from a three-year high to a one-year low.

Equities were also showing signs of fatigue. After a 4.2% pull-back in early August, the S&P reclaimed its lost ground to finally close above 2,000 for a fresh all-time high. Yet as the index struggled to stay above that milestone, it looked like a head-and-shoulders pattern had been forming, a sign that the market was getting ready to roll over and dive.

Suddenly at the end of last week everything changed, with analysts raising their forecasts and upping the ante:

“The 15 top strategists tracked by research firm Birinyi Associates are now penciling in average year-end forecast of 2,010 versus an average 2014 prognostication of 1,934 in December 2013,” reports Market Watch.

Deutsche Bank strategist David Bianco increased his S&P 500 year-end target from 1,850 to 2,050, with a call for 2,300 by 2016, while Gina Adams of Wells Fargo replaced her year-end target of 1,850 with a 12-month target of 2,100.

What were these two cards recently dealt to us which changed everyone’s game plan? The announcement by the European Central Bank for a fresh round of stimulus in Europe, and a poor employment report in the U.S.

Two Bullish Cards

The first surprise card drawn from the economic deck came Thursday, September 4th, when the ECB announced a new round of stimulus in the amount of 700 billion euros (over $900 billion), as well as a plan to purchase asset-backed securities to help the banks recapitalize, somewhat similar to the U.S. central bank’s monthly bond buying program.

This resulted in a plunge in the Euro, as flooding the market with money does to any currency. In turn, that resulted in a strengthening of the U.S. dollar, lifting the DXY dollar index from 82.8 to as much as 84.5 over the following days. And this sharp rise came on top of an already strengthening dollar which has been rising since the beginning of July.

But isn’t a stronger dollar bad for the economy? Why would this cause analysts to swing from bearish to bullish?

In normal times, yes, a stronger dollar would be a headwind for the economy, as it makes money more expensive and increases the cost of doing business in America. But these aren’t normal times. A strengthening dollar is similar to an increase in interest rates. Thus, if the U.S. dollar is already strengthening due to other currencies weakening, then the U.S. Federal Reserve cannot raise interest rates as soon as 2015, which most had been expecting. In essence, the ECB has preempted the U.S. Fed’s tightening move.

The second bullish card was drawn from the economic deck the following day on Friday, September 5th, when the August non-farm payroll number came in at just 142,000 new jobs, grossly under the estimate of some 220,000 new jobs.

This means the battle against unemployment is still raging, which will again hold the Fed back from raising interest rates as early as many were expecting. Remember that “maximum employment” is one of the Fed’s two mandates, and it won’t raise rates until it is satisfied that job creation is sustainable. Analysts are now pushing back their expectation for the first rate hike from mid-2015 to early-2016.

Incidentally, an interesting historical statistic supports a strong equity bull run to the end of 2016 – namely the four-year presidential cycle. The years 2015 and 2016 will be the third and four years of the current cycle, which are the strongest of the four.

According to the Stock Trader’s Almanac, since 1833 the Dow Jones Industrial Average has averaged +10.4% in the third year and +5.8% in the fourth, as compared to +4.2% in the second and +2.0% in the first. This means 2015 will be exceptionally strong on account of both this historical statistic and the Fed’s continuing low interest rate accommodative policy.

Does this mean, then, that equities are in and bonds are out? Almost, but not quite. There are still two more cards to be drawn – these ones from the geopolitical deck.

Two More Cards May Bring Turbulence

In normal times a protracted bull run would mean staying out of bonds. But again, these are not normal times. Two more cards about to be drawn from the geopolitical deck may introduce a lot of volatility over the next several quarters, making bonds as valuable as ever in weathering the storms.

Those two cards are the continuing geo-political struggles in eastern Europe against Russia, and in the middle east against the insurgent terrorist army ISIL.

In Europe, Russia’s invasion of Ukraine is forcing NATO to increase its presence in eastern Europe, with an emergency meeting in Switzerland earlier this week cementing the organization’s resolve. This conflict has only just begun and will grow increasingly more heated as the autumn turns into winter.

Given Europe’s dependence on Russia gas and oil for heating, it is expected that Russia will soon begin turning off its taps, further slowing Europe’s already crawling economic recovery. This is expected to increase fuel prices on international markets, as Europe will be drawing down the market’s stockpiles. In turn, rising oil and gas prices will tax western economies including America’s.

As for the Middle East, U.S. President Obama yesterday announced plans to send observers and advisers to help the new Iraqi government mount an offensive against the rapidly advancing forces of ISIL, which have been confiscating territory from western Syria to eastern Iraq. Although the President stressed this would not mean actual military involvement of U.S. troops, some indirect support through air strikes and weapons procurement are not only inevitable but have already been taking place for several weeks now.

With such continuing uncertainties – from increasing ECB stimulus which results in a stronger USD, to reduced supplies of oil and gas resulting in higher fuel prices, to increasing military activities for NATO and the U.S. in Europe and Iraq – we can expect a bumpy ride from here to 2016. The overall trajectory will be up, but with much more turbulence than we have been accustomed to over the past five years since the recovery began.

A Blend of Equities and Bonds

Bank of Montreal Chief Investment Strategist Brian Belski is one who expects more volatility in equities going forward. “Despite the market’s strength, we still remain comfortable with our now more cautious stance,” Belski noted in a recent letter to clients. “We would begin to change our minds if stock prices can prove they can remain strong against improving economic conditions and the associated higher interest rates that are likely to follow, while avoiding a major geopolitical shock.”

This seems to be the new way that Wall Street is playing its hand – a bullish walk with cautious step.

Investors would thus be wise to maintain a nice balance between equities and bonds going forward, perhaps at a 70:30 ratio (70% stocks and 30% bonds). When the expected dips and pullbacks in equities present themselves, investors would simply move a little out of bonds into equities, changing their ratio to perhaps 80:20 (80% stocks and 20% bonds). But once the market climbs back up to the previous high, don’t forget to rebalance back to that 70-30 mix, locking-in your gains as you wait for the next buying opportunity.

The two bullish cards picked up on Thursday (ECB stimulus which strengthens the USD) and Friday (weak jobs data) have pushed the expectation for interest rate hikes into 2016. Yet two more hard cards from the geopolitics deck (conflicts in Ukraine against Russia and in the Middle East against ISIL) are keeping bonds very much in play to help investors ride out the shocks.

Joseph Cafariello