Climbing the Wall of Worry

There is a preconceived notion by the general public that when the market is making new highs, everyone is happy and when the market is headed lower, everyone is crying. Although this is an epic generalization, it describes what I have noticed as the general public’s perception. Some of my friends who are not in the financial industry, but know that I am, ask me “Did you see the Dow was up 150 points, I bet you are happy”. Well, no and yes. My personal stock/mutual fund portfolio might have done well that day, but that does not mean I am happy with the gains. I also have to consider our fund which takes a market-neutral approach. Instead, I look at it a different way (but in the long run, it is all about gains and losses).

My perception is to take a macroeconomic approach and then decide whether or not the gains were justified in any way, shape or form….and justified movements are not always the case.
First, I would have to define a justified move in the market. Gains in the market might be justified by a cut in rates (helping spur economic growth), increased consumer activity, important economic data showing growth, or an entire sector/industry that has proved resilient and continues at a solid growth rate. Growth remains a key (yet not the only factor) to justify market gains, but it does not always have to be economic growth pushing the market higher. Instead, the market moves on the lack of news and can easily climb a “wall of worry” as the market somehow finds a goldilocks formula for good news and bad news that can send the market screaming higher; also known as financial alchemy. A move lower can be justified in numerous ways as well, but for simplicity reasons, assume that we can justify losses with the opposite reasons we can justify gains.
Obviously, I just described an oversimplification of the market’s movements. Gains are not always justified, losses are never simple and although we would like to believe the market prices in full information rationally, it doesn’t. That makes market periods like the one we currently have a difficult period as an investor, fund manager and consumer (also the reason for this article). Let’s take a look at a few of the reasons I am having a difficult time justifying the latest movement in the market.
1.Interest Rates – Yields on the 10 year bond have climbed from 4.7% to 5.1% (8.5%) over the past 60 days. This increase reflects the bond markets opinion that there are no fed rate cuts in the near future. This should affect the market negatively (and it did for about two seconds, before running to new highs). (click thumbnail to enlarge)
2.Energy Prices – Crude oil has climbed from around $61 to near $73 (19%) in the past 60 days, yet it seems to have no effect on the market. I had grown accustomed to seeing green in oil and red in the market, but maybe I am wrong in that simple assumption (it’s always easier to simplify). We have seen the rise in oil hardly being talked about anymore as consumers have apparently brushed it off their shoulders, yet it will still affect consumer’s budgets in the long run. (click thumbnail to enlarge)
3.Housing Market – We knew it was coming, yet we didn’t know when. We know there will be a bottom, but we don’t know when. Take a look at the House Price Index chart below from the OFHEO (Office of Federal Housing Enterprise Oversight) and you can see where we are today. (click thumbnail to enlarge)
4.Subprime loans – Many have gone into default and many more will follow. The end is not here and there is a mixed discussion on whether these issues will be contained or will spread into other issues. Time will tell. Some say that the Bear Stearns Subprime hedge fund woes are the first to come to shore, but there will be many other struggling funds to wash up in the near future.
5.Economic Growth – Slower growth across the corporate world has lead to slower economic growth. Although GDP estimates are higher for the third quarter than the first and second quarters, the trend is still towards lower growth. With an increase in the PCE Chain Deflator (see below) and lower growth in the future, it would seem as if the market would struggle with this notion. (click thumbnail to enlarge)
Although the overview seems gloomy, the stock market seems rosy as it continues to approach new highs. That does not fit with my view of how the economy and stock market work in relation to one another. Yes, there are definitely times of misalignment, as the current environment may be a perfect example, but how long can we climb the “wall of worry”. As we continue to press toward new highs in the major markets in the U.S. and abroad, it will only be fitting if we were to squeeze out as much as possible before having to consolidate gains. But watch out for fake-outs as these have been buying opportunities. Timing is never something we practice, but I believe there will be a major move to the downside at some point in the next 6-8 months. That said, a move higher of the same proportion would only taunt my psyche and elevate concerns even more.

Sources: Reuters,, OFHEO, Yahoo! Finance

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