February 04, 2011
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Following last Friday’s sharp drop in global stock markets, the long-awaited correction appeared to have arrived. Markets have been ripe for a pullback for a number of weeks; the upheaval in Egypt merely provided the catalyst.
After Tuesday’s session, in which the S&P 500 broke above 1300 to a new bull market high, the stock market now seems to be confounding those expectations. Technically, stocks are essentially back to their position prior to last Friday’s decline – at the upper boundary of an upward price channel that has been in effect since early December (Exhibit 1).
Despite Feb. 1’s very bullish action, the odds seem to favor a correction similar to the one we saw in November (i.e., approximately three weeks in duration and 4% to 5% in magnitude). On the S&P 500, initial support comes in around the 1250 level, at the 50-day moving average. Continued or heightened geopolitical unrest in the Middle East could provide the backdrop for a move to lower levels of support around 1225, which was prior resistance from November.
Looking out over the next six months or so, our stock market outlook is neutral. We see plenty of catalysts that could cause the bull market to hit a wall, but we are also aware that for the time being "super- liquidity" may indeed trump every other consideration. Even bearish analysts seem to have capitulated and concluded that, until the next debt-related crisis hits, the stock market will inevitably levitate as long as “real” (inflation-adjusted) short-term interest rates are kept in negative territory by the Federal Reserve.
Equities today are winning by default against a backdrop of negative real interest rates and dislocations in the municipal bond market. Given that we still have negative TIPS yields (a proxy for “real” interest rates) out to 5 years in maturity, and that market participants currently expect only a token quarter-point increase in the fed funds rate in late 2011, equity markets seem to have a green light to continue their grind higher.
It is striking how the negative interest rate environment stultifies investment analysis. A recent case in point: in his most recent quarterly letter, market valuation guru Jeremy Grantham of the institutional fund manager GMO estimated that “fair value” on the S&P 500 is only 910, but due to liquidity factors, the index could rise all the way to 1500 in 2011!