Look for a rally

As you know, we have been cautious towards economic growth and stock exposure for some time. From a longer-term standpoint, we maintain our concern that we are, and have been, in a secular bear stock market.

This bear market has been in existence since the year 2000, which is due to the world’s position of over-leverage relative to potential growth. However, during certain periods we need to continue to look for opportunities to take advantage of shorter-term price movements.

Opportunity – Detail

We sense a short-intermediate term opportunity may have arrived for investors to emerge from the “trench” in which the U.S. stock market has been trading for the majority of the summer months. Since mid-May of this year, the S&P 500 Index has been trading within a relatively narrow range, bounded by 1040 on the downside and 1130 on the upside. Overthis period of time, the market has been wrestling with:

• The “flash crash” and why that occurred
• The Greek debt problem followed by concerns in Portugal, Spain and Italy
• Economic disappointments from GDP releases to renewed weakness in housing
• Employment trends faltering
• Concern about the sustainability of the current economic expansion, and questions about the establishment of a “double-dip” economic environment
• Possible changes in Washington with the upcoming midterm election
• The sustainability of strong earnings comparisons and whether this will last

As these issues have rolled through investors’ minds, the stock market has moved back and forth within the 8.6 percent range mentioned above.Over the last few weeks, a number of the above worries are becoming less intense. The “flash crash” is becoming a more distant memory.

The latest round of the Basel Accords appears to have put the European banking problems on the back burner. If weakness in employment, housing and GDP trends continues, the potential of the Fed coming into the market, purchasing assets and infusing capital into the system appears to be high. This is altering investors’ view as to the potential for the economy to truly enter a new growth contraction phase.

It also appears the Republicans will pick up a number of seats in the House and Senate in November, leading to “gridlock” in Washington. Will this be enough for businesses to become more comfortable that no new major policy issues are forthcoming from Washington? Will this view provide comfort for business leaders to start expansion plans by hiring more workers and to make significant capital investments?

The answers to these questions are, of course, unknown. However, the possibility of these questions being answered may be enough to fuel a shorter-term rally in the U.S. equity market.

Fed Activity

Recently, the market has made a move above this summer’s trading range, closing at 1139 on September 21. Additionally, speculation is intensifying that the Fed may enter another round of “quantitative easing,” infusing significant capital into the banking system in an attempt to re-ignite economic growth. If GDP growth starts to accelerate above expectations, the stock market should rally.

If economic growth is not forthcoming, the Fed very well may enter another round of quantitative easing, providing substantial “ammunition,” which may fuel asset values to the upside.

Seasonality

According to Ned Davis Research, the months of October, November and December historically have been months where stocks have outperformed bonds. Over the last 84 years, stocks have outperformed bonds 57 percent of the time. During the months of October, November and December, stocks have outperformed bonds. On average, stocks have outperformed bonds 61 percent of the time during the fourth quarter.

The Dollar

Many issues tend to change valuation levels within the world’s currency markets. Two major factors whichdrive exchange rates are:

• Economic growth rates – the higher the growth rate an economy displays (on a sustainable basis), the stronger the currency of that country tends to be.
• The lower the supply of currency in relation to demand, the higher the currency will tend to trade. This factor favors countries that have their debt demands in hand. In other words, countries
which are consistently coming into the bond market, borrowing more money, tend to display weaker currencies.

We believe the U.S. dollar is entering a period of weakness in relation to foreign currencies. This should favor investments in non-dollar denominated assets. With this in mind, we believe foreign equities may perform well, along with domestic equities during this counter-trend rally, which appears to be unfolding. Additionally, gold holdings should do well, as gold has displayed a strong “negative correlation” effect in relation to the value of the dollar.

Final Word

Some will ask what our expectations hold for this move – how long it may last and how high the market may move. To tell the truth, we don’t know the answer to those questions. What we sense, is that the worries which have dogged the market over the last few months appear to be on the mend, at least for the time being.
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