The best rallies are those that move up, take a breather and then move up again. That way markets do not get extended, the gains are fairly predictable, as are the pullbacks. It appears that is the kind of market we are in at present.
The S&P 500 Index reached a low of 1,249 exactly one month ago. It then soared 7.2% to 1,339 in the next 23 days. We began this pullback a week ago and so far have given back less than 2% of those gains. I would expect a bit more time and possibly downside before resuming our march toward 1,400 on the S&P.
If you are looking for excuses (as so many of us do) to explain the short-term gyrations in the market there are plenty of culprits. If you are a Republican, it’s all about the runaway deficit and the opposition’s unwillingness/inability to tackle spending and raise taxes. Democrats will argue it’s the fault of the GOP and the Tea Party that narrowly missed shutting down the government by tacking on superfluous riders to the deal. I expect increased rhetoric and market volatility as the debate on the debt ceiling intensifies, so be prepared.
But all of that is simply headline news. The real questions that are making the rounds of trading floors and hedge fund offices are these: At what point does “non-core” inflation, (energy and food, for example) start to impact corporate profits? Are we already seeing some of that risk this quarter as companies voice their concerns about profit margins in the future?
When will the widening gap between America’s haves and have nots reach a boiling point? Over seventy percent of the population is caught in a terrible climate of stagflation while the top 30% get richer and richer. Higher commodity prices will eventually force producers to pass on price increases to consumers. Will these consumers demand higher wages in order to stay afloat? Will corporations respond by raising worker’s income or will they hold the line? If they hold the line, will that mean consumer spending retreats and the economy slows? Either way, corporate profits will suffer.
Overseas, Spain’s real estate losses are massive and at some point will come to the forefront. How will Europe and the world meet that challenge? Spain, unlike Greece, Portugal and Ireland, is a big economy and problems there would have a severe impact on other economies.
Will China be able to continue its role as the world’s economic locomotive? The government is struggling to engineer a “soft landing” as it attempts to control/reduce inflation while maintaining a high growth rate. At best, this is a difficult task and if they over tighten, causing their economy to falter, what will that do to global economic growth?
At the center of this debate is QE 2. There is an extremely high correlation between the rise in commodity prices, the stock market and the Federal Reserve’s open market purchases of securities. The ripple effect of QE 2 has spread all over the world and the above questions center on what happens with the end of QE2 in June.
The Fed is flooding the economy with money and that money is sitting in bank vaults and on corporate balance sheets. So there is plenty of money to hire workers and raise wages to pay for those higher prices brought on by sky-rocketing commodity prices. Of course, what I am describing is the beginning of an inflationary cycle that, if left unchecked, could lead to hyper-inflation.
Given that no one knows how this story will turn out, one can forgive the two steps forward, one step back volatility in the markets. Gold and silver continue to rocket higher since all we can be sure of right now is that the Fed will continue to pump money into the economy until June. It is also why I believe the stock market, regardless of these short-term pullbacks, is heading higher for now.