Tuesday, January 1, 2013

Stuck Inside Another Post Stimulus Hangover

U.S. stock market performance remains puzzling to say the least. For a few weeks, the stock market will have the look and feel like it’s simply going to fall apart. Then, almost magically, the mood suddenly changes and stocks spend a few weeks floating euphorically higher. Since the end of July, we’ve seen five such down-up cycles, and it appears that a new round is about to get underway with the stock market showing some signs of fatigue this week. Unfortunately, this is nothing more than another post stimulus hangover for stocks. And the final ending may not be as pleasant the second time around.

The recent schizophrenic market behavior can be traced back to one key event – the end of QE2. Once Ben Bernanke confirmed that QE2 was on its way in Jackson Hole on August 26, 2010, the stock market began a smooth and steady ascent that lasted well into 2011. And even when the stock market began to falter starting in March 2011, the oscillations were still fairly even and extended. But once QE2 ended on June 30, the mood of the market quickly changed. After a few weeks of coasting into July, the bottom quickly fell out on stocks. Over the course of 12 trading days, stocks as measured by the S&P 500 lost -18%. And wild swings back and forth have followed ever since.

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Reflecting back on recent history, this recent stock market volatility comes as no surprise. For when QE1 ended back on March 31, 2010, stocks traveled on nearly the same exact path – initial coasting followed by a cascade decline and subsequent violent volatility. Overlaying the cumulative performance of the S&P 500 post QE1 and post QE2 shows how similar the two experiences have been. Although the actual reasons for the swings may be different between the two episodes, the underlying forces are the same. What is this reason? A violent standoff in sentiment pitting "hope" against "reality."

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An assessment of both episodes reveals the similar forces. Initially after the end of QE, stocks continue to coast for a few weeks supported by the residual calm that persisted during the QE periods. But after a few weeks, the reality sets in that the economy is not strong enough to stand on its own and the debt problems that sparked the crisis several years ago are not even close to being resolved. Stocks cascade lower in response, causing great pain for market participants. But amid this pain, a sense of hope suddenly arises. The notion – things are getting so bad so quickly, surely the Fed and global policy makers will intervene to rescue the markets just as they have in the past. Suddenly the mood is lifted by the idea that happy QE days will soon be here again, and stocks begin to euphorically rise.

But after a few weeks of levitating stock market bliss supported by hope and rumors, a new wave of troubling news brings sobriety back to the market. And with the return of reality, a new plunge lower begins. And eventually hopes of rescue return once again, and the cycle up and down continues in a seemingly endless wave.

This raises a key question. Where does this all end? Do we finally break out higher or break down lower? The battle between hope and reality is currently joined, but one side will eventually win out. Either policy makers will come to the rescue, or markets will be forced to deal on their own with reality.

Back in August 2010, it was hope that won out. After chopping violently through the summer, the U.S. Federal Reserve came to the rescue with QE2. And after 106 ugly trading days from April 1 to August 26, 2010, the stock market’s post QE1 nightmare was over and the levitation to the upside began.

So will hope win out again this time around? At this point, the odds continue to favor reality over hope. It has been 77 trading days since the end of QE2 on June 30. At this same point following the end of QE1, the Fed was out in the media and the speaking circuit talking openly about the potential for more QE coming down the road. It was a promise they finally delivered come the end of August.

This time around, FOMC members have been far more reserved with their language. They offer few hints if any that more stimulus is coming on the horizon any time soon. And their independence is now under fire from Congress and a cast of vocal Republican Presidential hopefuls. As a result, they must move more cautiously and deliberately this time around. Beyond the Fed, the problems in Europe are considerably worse in October 2011 than they were in August 2010. The European sovereign debt crisis has escalated to the stage where there are no easy policy solutions and the potential for another major shock to the financial system is high. This coupled with the threat of the U.S. economy falling back into recession creates a fundamental reality for stocks that may become too stark to ignore before too long.

So as the stock market continues to work through its post stimulus hangover, we should expect to see stocks continue to cycle through staggering declines followed by equally sharp rallies. But at some point, markets will eventually arrive at a final conclusion. Either policy makers finally deliver on the hope that continues to periodically levitate the market, or the challenging global economic realities become too much for markets to ignore any longer. And given the magnitude of the current issues, particularly in Europe, coupled with the limited policy resources available to combat these problems, the likely outcome continues to tilt toward reality over hope. This implies that at some point, it would not be surprising to see stocks break decisively to the downside from its current trading range. Only time - or perhaps another 30 to 60 trading days - will tell.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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