After a week of slowly grinding higher on exceptionally low volume, the markets swooned on Friday. Europe, once again, was responsible.
It was almost comical to watch the talking heads this week as they tried to make a case that the U.S. markets were decoupling from the troubles in Europe. They highlighted the increasingly positive economic data, the possibility of quarterly earnings surprises and the hope that the Fed was preparing for another round of quantitative easing.
My take is that Europe has a longer holiday season than we do. Their movers and shakers just got back to work this week. We haven’t decoupled. There was simply an absence of market making news until this week.
All of that decoupling talk disappeared on Friday as a rumor surfaced that credit rating agency Standard & Poor’s was ready to downgrade a slew of European countries this weekend. At the same time, JPMorgan’s revenues disappointed the market in their earnings announcement, sending the entire financial sector into a tailspin. Retail sales for December (as I predicted) also disappointed the markets. The holiday season failed to live up to retailers’ expectations triggering fears that future economic growth was in jeopardy.
My advice to readers is to ignore all these one-off events. The simple truth is that we have benefited from A) The Santa Claus Rally and B) the January Effect. In my last few columns, I explained both and predicted the markets would rally as a result. Both A and B came off like clockwork and are now about over, leaving the markets vulnerable to a pullback.
I’m not looking for anything disastrous to develop, outside of a normal two-steps -forward, one-step-back kind of decline. There are too many positive developments for me to become overly bearish.
Both Italy and Spain managed to sell 17 billion worth of sovereign debt ($21.5 billion) this week without too much trouble. That was a vast improvement over last month when few players were willing to even look at buying bonds from these countries. The European Central Bank left rates unchanged, leaving the door open for possible rate cuts in the future. Even Greece, the bad boy of Europe, is stumbling towards a debt deal in their typical on-again, off-again fashion.
There is also a lot of talk about the possibility that the Fed will launch QE 3 sometime in the next few months. This is partially a result of some dovish sounding speeches from several Fed members lately. I have my doubts. As long as U.S. economic data continues to improve, I don’t think the Fed sees the need for additional monetary stimulus right now.
Of course, we are in an election year and sitting presidents in the past have been known to “lean” on the chairman of the Federal Reserve to goose the economy as November approaches. I think it is still too soon for that kind of monetary monkey business before the elections. But it does help buoy the mood of investors so we will put that in the plus column.
In summary, the markets will pull back and then go higher. That will be a trend I expect will continue for the next several months. I’m not looking for big gains, just a general trending higher by the indexes, interrupted by pullbacks on a periodic basis. The upside could lift the S&P 500 Index to the 1,350 level but from here that’s no more than a 5% gain from here. As such, we will keep one foot in dividend paying stocks and the other in the fixed income market. In other words stay defensive.