Raul Elizalde - August 23, 2012
Stock prices climbed strongly since the lows of June, but doubts about the rally have grown as prices moved higher and higher.
Strategist Bob Janjuah from Nomura, for example, predicted in a note published on 8/21/2012 that the S&P500 “is likely to fall by 20-25 percent over the next three months.” Therefore “the correct thing to do […] is to prepare for a serious risk-off phase between August and November” which means that he is “happy to risk 30 S&P points against us, in order to potentially pick up 300 S&P points in our favor.”
Richard Ross, global technical strategist at Auerbach Grayson in New York, was quoted by Reuters on 8/17/12 as saying to their clients: "We implore you to raise cash into strength ahead of a sharp and swift late summer squall."
We too expressed concerns about the rally in our last newsletter (Waiting for the big bazooka, 8/13/12). We noted the discrepancy between higher stock prices and worsening economic conditions, lower earnings forecasts, and technically dangerous volatility levels. An identical sentiment was voiced on 8/21/12 by Philipp Baertschi, chief strategist at Sarasin in Zurich, who predicted that “the paradoxical situation of rising equity prices and deteriorating economic data will not last long” and should lead to “equity prices to drop sharply until the end of the year.”
Clearly we are not alone in thinking that the market is standing at a perilous edge, supported by the expectation that the US Fed or the European Central Bank will intervene. The question is how realistic are those expectations.
First, it seems unlikely that the Fed would embark in a large round of liquidity injections as long as the economy continues to waddle along, stock prices don’t fall too much, and rates remain close to historical lows. According to Fed minutes, some more monetary accommodation might take place if the economy worsens. On the other hand, Fed Chairman Bernanke is aware of the declining impact of the Fed’s operations.
US monetary policy has reached the end of the line. The two main issues that the US and the world face - the US “fiscal cliff” and the threat of eurozone disintegration – can easily overpower any possible Fed action.
This is because a clear resolution of both issues would arouse the world more than any Fed action could, while failure to solve either would precipitate a crisis that can easily overpower the Fed’s Maginot lines. Confronted with this reality, the Fed may well choose to operate in the margins, if at all.
So that leaves the ECB as the player to watch. It already has denied rumors that it will cap financing costs for the European periphery, at least before rescue funds are activated. This is a considerable hurdle for intervention in the short term. Additionally, the German central bank reiterated for the umpteenth time its opposition to the direct financing of troubled nations by the ECB.
Still, the ECB’s president said he would do “whatever it takes” to save the euro. Those were powerful words that already reduced borrowing costs for Spain. This is classic central bank jawboning: a good statement can accomplish a lot without having to actually do much.
Perversely, this success has lowered the likelihood of intervention, which weakens the basic rationale behind the stock rally and puts equity markets at risk. Sooner or later real action will be needed to keep stock prices afloat.
So that’s the narrative. Technicals and fundamentals are weak, prices are only supported by the hope of central bank intervention, and disappointment is just around the corner. Most market participants believe it, and they are waiting for the market to crash.
This, however, raises an interesting question: can the market crash if everyone expects it to?
This is an important question. While a spike in volatility appears inevitable, the strong consensus behind it may well prevent it from taking place. As in physics, the observer can affect the outcome. Indeed, it does not seem intuitive that a “sharp and swift late summer squall” could be so widely and easily predicted.
It is nonetheless possible that a sudden negative event can hit the market. An unfavorable ruling by the German courts declaring euro-bailout proposals unconstitutional, a chaotic exit by Greece, or a flare-up of political strife anywhere in the globe are some of the events that can trigger a crash, even if everybody is in high alert.
But a more insidious outcome than a spectacular crash could still unfold. The 3-year-long bull market could be coming to an end, giving way to a slow but prolonged bear phase. This is possible if global economic output declines, dragging markets down for many quarters.
Gloom is not inevitable. Better markets are possible if the US economy muddles through, the fiscal cliff is avoided, and political discontent in Europe is held at bay. It is not impossible for Europe to adopt policies that foster growth and restore competitiveness for its weakest members, or for the US to avoid the fiscal cliff. If that happens, a return of confidence could lure back the mountain of money that exited equity markets which would render massive central bank help unnecessary. Markets could then climb even more. But for now, the chances of this alternative narrative seem low.
