Blog : Why There Still May Be Upside

by Ed Zwirn on September 2nd, 2014

We may have gotten a free pass from the summer doldrums this time around but will this help our case going into the colder months?

As the investing public has been made well aware, the Standard & Poor's 500 index crossed over the 2,000 threshold last week to close Friday at 2003.37, the 32nd record it has hit so far this year. And while it is tempting to dismiss this milestone as a meaningless construct, the stock market has performed strongly this summer however you slice it.

As measured by the Dow Jones Industrial Average, the market gained 3% between Memorial Day and Labor Day. Looking at penny stocks, risk appetite increased at a healthy pace over the summer, with the penny stock-rich Russell 2000 index outperforming the Dow to score a 4.3% gain.

These gains were most pronounced in the latter part of the summer, with the DJIA gaining 1.4% in August alone and Russell 2000 outperforming to score a 4.8% spike. This reverses the pattern seen one year ago (and more typically), when the stock markets languished, and tanked most sharply in the latter part of the summer.

This rally, during which the current bull market has passed the five-year mark, begs the question of whether the good times can last. But whether or not a "surprise" correction is in fact in the offing, as many quantitative analysts suggest, is far from certain for a number of reasons:

-- For one thing, broad investor sentiment can be looked at as a contrarian indicator. For this reason, the wider the currency given to doom-and-gloom outlooks, the greater the chance that canny investors are already pricing these into their strategies, meaning that the element of surprise (and catastrophic impact) will likely be missing whenever stocks begin to reverse themselves.

-- For another, there is the strong possibility that this bull may have more room to run. And this is not a statistical impossibility. Looking at the not-too-distant past, the so-called dotcom bubble was more than 12 years old before it burst in Y2K, and two other bull markets since the end of World War II have lasted longer than the current rally.                                        

Investors may or may not be returning from the Labor Day weekend with visions of buy orders dancing around in their heads. But there are indications that the stock market may be boosted by fundamentals, at least if you go by the recent performance of the U.S. economy.

As the Bureau of Economic Analysis reported last week, the revised estimate of Gross Domestic Product showed a 4.2% rise for Q2, up from the earlier estimate of 4% and a sea change from the 2.1% decrease registered in Q1. The increase in GDP in Q2 was mainly driven by positive contributions from personal consumption expenditures and an increase in private inventory investment. Real domestic purchases - purchases by U.S. residents of goods and services wherever produced - increased 4.5% in Q2 after falling 0.1% in Q1.

This economic pickup has led to an upsurge in Fed contrarian trading, according to which the "good" news we have been seeing both on spending and the labor market could prompt the U.S. central bank to raise interest rates sooner than later.

Witness the unusual amount of attention paid to the Aug. 20 release of the Federal Open Market Committee meeting minutes of July 29-30, which was closely parsed for the increasing discussion on the part of the Fed governors as to when to remove "policy accommodation."

This type of trade will soon surface again on Sept. 17, with the release of the next Fed monetary policy statement. But the hype about U.S. monetary policy notwithstanding, Americans often forget there are other economies out there. Of the major world economies only the Chinese (which are slowing down at any rate) has any inflation in its forward outlook. Japan, on the other hand, has been suffering from deflation for decades, and it looks like Europe is facing the same threat. Analysts are widely expecting the European Central Bank, which recently introduced negative interest rates, to expand its policy accommodation even further as soon as Sept. 4, when it holds its next monetary policy press conference.

The bottom line for stocks: Things may have picked up for both the U.S. economy and the stock market this summer, and this has resulted in the type of mixed outlook for stocks usually seen in a late-stage bull market. At the same time, there is virtually no risk of substantial interest rate hikes coming any time soon, however much things may continue to pick up.

As pointed out previously in this investment blog, the Fed cannot raise its interest rate targets at the same time as the ECB is moving in the opposite direction, at least not without causing a rally in the dollar and hitting the U.S. export economy with a serious blow in the process. That's not to say the Fed governors can't do that if they want to, but that they would be hard pressed to tighten unless inescapable evidence emergences that things are heating up too fast. In the meantime, rates will stay low, along with inflation, making investors even more hungry for yield.