Wednesday, December 9, 2009

Has Bubble Ben Shown His Hand?


Martin Roberge, Portfolio Strategist & Quantitative Analyst at Dundee Capital Markets, sent me his latest comment, Fed's Bernanke Has Shown His Hand: No Rate Hikes! Should Equity Investors Celebrate?:
On Monday, Chairman Ben Bernanke provided an economic update at the Economic Club of Washington. In our view, the key takeaway from his speech is the non-conventional tightening mechanisms the Fed intends to use when economic conditions warrant a tighter monetary stance. While such mechanisms imply a prolonged period of low interest rates, history shows that a trading-range environment for the stock market remains the most likely scenario next year.

It may be just our imagination, but after reading Ben Bernanke’s speech a few times, it seems that the next US monetary tightening cycle will be initiated through Japanese-like monetary mechanisms as opposed to conventional rate hikes. Indeed, the Fed spent a great deal of time explaining how it can apply upward pressure on short-term interest rates by: 1) raising rates on banks’ balances sitting at the Fed, 2) using reverse repurchase agreements, and/or 3) reducing the size of the Fed’s balance sheet.

The net result is a prolonged period of low interest rates. Also, as in the 70s and 80s, US monetary aggregates could become the mean to gauge the Fed’s monetary bias. But what does it mean for equity investors?

It has been 12 months since US Fed funds were cut to 25bps. A similar status quo on short-term rates was seen in 2003-2004 (12 months), 1993-1994 (16 months) and 1983-84 (17 months). Interestingly, these episodes are all post-recession periods and the chart at right shows that the stock market has tended to behave erratically 12 months after the last Fed cut. Obviously the apprehension of higher interest rates is what causes market choppiness, with the possibility of double-digit corrections.

But the key here is that history suggests a trading-range strategy for equity investors in 2010, where stock market weakness is bought and strength sold. This is a view we have expressed and supported in recent strategy wires to justify a neutral equity stance in our tactical asset allocation.

Bottom line: Consistent with the Fed’s views, investors have priced out Fed rate hikes for the next year. However, this does not necessarily represent a green flag for equities. History suggests that prolonged periods of low interest rates have translated into much market choppiness. Accordingly, a trading strategy of selling strength and buying weakness may be optimal in 2010.
While choppy markets look very likely, some managers still advise to just be long for 2010:

Amid doubts about the economic recovery and a sense the stock market has come “too far, too fast,” many are questioning whether the rally can continue.

But such negativity is precisely why investors should view dips like Tuesdays as opportunities, according to Jeff Saut of Raymond James and Jon Markman, author, money manager and newsletter writer.

“I never thought you could be a contrarian by being long in a bull market but that’s where we find ourselves,” says Markman, who pens the Strategic Advantage and Trader's Advantage newsletters. I‘ve never seen a bull market were there’s so little joy. [investors] are so morose. As if it’s going to fall apart right away.”

Looking ahead to 2010, Markman said the best advice for investors is “just be long,” recommending “risk assets” like emerging markets and the Russell 3000 ETF because it provides exposure to both small- and large-cap stocks.

Saut, who has been writing extensively about the “performance anxiety” facing underperforming fund managers, largely agreed with Markman’s assessment, although he thinks big-cap stocks are likely to outperform in the near term.

Both pundits also agreed gold’s long-term prospects remain bright even as it’s now suffering an overdue correction.

Still, Saut was less ebullient than Markman, citing a number of “headwinds” likely to hit the market in the middle of 2010, including higher inflation and interest rates, more government regulation, the demise of the “sugar high” from the 2008 stimulus, and the political risks of a mid-term election.

“I feel pretty good into the first quarter of next year…there’s still way too much cash in institutional coffers,” the strategist says. “It’s important to be long but once you get into the second and third quarters you’re going to start to see some headwinds. That doesn’t necessarily mean stocks will go down.”
If you listen to the interview, the parallel to 1991-92 is worth noting because everyone expected a double-dip recession back then that never materialized. What I see in 2010 is speculative pockets going into specific sectors or stocks.

Clearly Bubble Ben has shown his hand but don't be so convinced that the Fed will not raise rates in 2010. If the recovery comes in stronger than anticipated, you might see some significant rate hikes in the second half of 2010. That's when the markets will really get interesting.

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