Going Over A "Cliff" Never Felt So Good...

As we approached the end of 2012, widespread fear of going over the so called “fiscal cliff” was running rampant. In fact, based on the non-stop media onslaught, it felt more like we were approaching the edge of Niagara Falls in a barrel! As most are by now aware, Congress in-fact took us over the “cliff”, but instead of a terrifying drop, our barrel turned out to be a rocket, kicked in the after-burners and gained altitude.

One of the questions now being asked is, why did the U.S. stock and commodity markets soar in January when the big problems related to the “cliff” were not really addressed?

We can find the answer by revisiting Econ 101. What fundamental forces affect the market price of just about everything (Stocks, homes, goods, services, etc.)? Our old friends, Supply and Demand. All of us can remember a few years back when the demand for real estate far exceeded the supply. Housing prices went up dramatically, rising over 100% in many areas. Sadly, still fresh in our minds are the more recent few years when supply far outpaced demand, leading to staggering price declines. These fundamental forces are usually at play in a free price system that establishes market values for everything from goods and services to individual employment and incomes. Why have stock prices gone up? Demand, plain and simple.

So how does one gauge demand? Various metrics and indexes have been created to try and assist in determining past, existing and future demand, and billions of dollars are spent each year by corporations, governments and investors trying to predict future demand and gain an informational advantage over the competition. But, alas, no system is perfect, and any method can often can be wrong as often as it is right. It’s a little like my favorite economic forecasting joke (yes, I have one) that refers to Economists having successfully forecasted 9 out of the last 5 recessions! This is not meant to imply that there aren’t tools available to help improve one’s probabilities of success, because I believe there are. For example the price trend (shown in the chart below) can help one understand what imbalance may exist between supply and demand.

Other quantitative and technical indicators, studies and tools also exist. One example of these would be the study of trade volume on advancing securities vs. the trade volume on declining securities. When advancing volume exceeds declining volume, this can indicate that demand is greater than supply. Alternatively, when declining volume exceeds advancing volume, supply is likely greater than demand. Regardless of which indicators are used, it is important to understand that indicators are not perfect and are at times subjective. It is through the consistent application of these indicators that one can improve the decision making process and increase the probabilities of being on the right side of the prevailing trend.

So why has the demand been greater than supply in the stock markets over the past few months, especially in light of the “Fiscal Cliff”? Sometimes it is very difficult to understand the “why” of a price move because the reasons can be numerous and unapparent to the reporting media. However, a few points bear mentioning. First, the Federal Reserve has been buying $85 Billion a month in mortgage and Treasury bonds and will continue to do so while inflation remains under-control and unemployment remains high. This has pushed interest rates down across the board, making reinvestment into bonds unattractive. As institutional investors search for places to reinvest maturing bond money, the more attractive opportunities have been in the stock market. For example, last November the dividend yield of Proctor and Gamble hit a high of about 3.4%, compared to a yield on 10 year treasuries of about 1.6%. At that time an investor in Proctor and Gamble would not only collect more than double the yield, but would possibly participate in price appreciation of the shares over the long term whereas the principle in the 10 year Treasury is fixed. That information, coupled with data that suggests that the economy has been doing better than most people believe, created a strong case for investing in stocks.

What is the data showing a gradual improvement in the economy? Strength in the housing market, a rebound in manufacturing, favorable credit conditions, and 28-year lows on the household debt service ratio are among some of the aspects of evidence that point to the fact that things continue to improve. This has helped remove some of the uncertainty surrounding the state of the economy and has encouraged additional risk taking by investors in the form of increased equity exposure. In addition, for the first time in almost four years, stock mutual funds have started to see positive cash inflows (about $0.8 billion/day, as compared to the $365 billion in capital withdrawn over the prior three years). Evidence shows that retail investors tend to chase returns, so the largely unexpected good returns in stocks last year, combined with the bond yield pressures mentioned above, favor a continuation of the capital inflows trend. These are just some of the possible reasons that have led the market to climb, in- spite of the perceived dangers that might lie on the horizon.

Where does this leave us for 2013? We currently think the probabilities of seeing record highs in stock and commodity markets have increased significantly. When we started 2013, the S&P 500 index was about 10% away from a record high and by the end of January the gap was at about 5%. That being said, our indicators currently show that optimism has become a little too pervasive, and so we would not be surprised by a correction in the markets. While our base scenario calls for a near-term pullback, the indication, supported in part by data outlined earlier in this article, would call for a downside limited to the 5-10% range. This should give investors a good entry point for deploying additional capital, but having seen how quickly the market can move from pullback to rebound, investors would be wise to have such capital deposited in their investment accounts, awaiting deployment.

- Greg Stewart, CIO