November’s corrective action in the stock market appears to have been a consolidation of the strong advance in the autumn, and not the start of a deeper intermediate-term decline. The correction lows may already be in place around 1175 in the S&P 500, or will be put in place over the next two weeks in the event of another retest of the recent lows. In either case, the stock market should regain its upward bias in the months ahead. Longer-term secular risks associated with the endgame of the debt problem have not changed, but the environment in the first half of 2011 is likely to be conducive to higher stock prices for the following reasons:

Stock market resilience points to higher prices. The stock market action this past week has been impressive, and indicative of a market that wants to go higher. After spending the second half of November moving back and forth within a 25-point range between 1175 and 1200 (Exhibit 1), the S&P 500 broke decisively through resistance on Wednesday, had another powerful upside thrust on Thursday, and is not giving back much ground today despite a very weak November jobs report. Stocks had plenty of reasons to suffer a deeper decline in November than the 5% correction that occurred. The stock market was overextended coming into the month, having gone almost straight up in September and October. In recent weeks, the market has been tested by a series of adverse developments overseas. The European debt crisis returned to the forefront; China moved to tighten policy in response to a growing inflation problem; and North Korea made an aggressive military strike against South Korea. In the U.S., the Fed has been under attack – raising questions about the fate of its quantitative easing program – and tax policy in 2011 remains unknown. Against this backdrop, the ability for stocks to correct only modestly, and in the past few sessions recover most of their lost ground, reflects a healthy supply/demand condition, which suggests that the market is preparing for a new leg to the upside.

Exhibit 1

European debt “contagion” fears appear to be receding (for now). The latest installment of Europe's debt crisis will apparently be papered over in the usual manner -bailing out banks with public funds, rather than restructuring debts and allowing bank bondholders to suffer losses. Moreover, in an effort to prevent the “contagion” from spreading to other “peripheral” countries such as Portugal and Spain, the European Central Bank (ECB) is intervening to buy the bonds of countries that are shunned by the private markets. Eventually, fundamental debt restructuring is inevitable in Europe, and the insolvent countries will need to go through a painful austerity process. It is hard to predict the tipping point, but eventually taxpayers in the more fiscally stable countries -led by Germany – will revolt against the bailouts and insist that the burden of fiscal adjustment be shifted to the insolvent countries, banks, and their bondholders.

European problems have reduced the risk of a U.S. dollar breakdown. Over the past month, the focus of currency markets has shifted from concerns about the Fed’s quantitative easing program to renewed debt problems in Europe. The U.S. dollar, which had been in a sharp decline since the Fed began laying the groundwork for QE2 in late August, and was getting uncomfortably close to key support levels (Exhibit 2), has enjoyed a nice rebound in recent weeks. With the euro equally suspect, we now have the illusion of a stable dollar, which is comforting to the stock market. It appears that for the next several months at least, the risk of a destabilizing breakdown in the U.S. dollar is off the table.

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