Volatility Will Continue To Spike

The equity markets have been stuck in a wide trading range for almost 12 years now, and it seems like there’s no end in sight. The last time this happened was the period from 1966 to 1982, when the stock markets essentially went nowhere for 16 years. It’s very possible that we could continue this volatile, sideways move for another 4 years before the structural problems are resolved and employment returns to a healthy level.

So, where is the bottom of this trading range? I think the bottom is 1250 on the S&P 500 index. This level represents a 12% decline from the April 2012 high of 1422. In order for the market to fall below this level, something bad would actually have to happen, as opposed to just threatening to happen.

Examples of what could go wrong are plentiful – breakup of the Euro Currency Union, China hard landing, high profile bank default, you name it. But I don’t think there’s enough evidence of these things happening in the current news reports, so for now, I’m drawing a line in the sand at 1250.

Global investors are worried, and with good cause. Concerns about the impact of the ratings agencies’ downgrades of sovereign debt, and the Euro Zone crisis, are creating a volatile and highly uncertain backdrop for the global markets. But we have faith that in the end, cooler heads will prevail, and the markets will find support based on a continuation of the fragile economic recovery.

It’s my belief that the global economy will get through the rest of 2012 without falling back into recession. But near term, I see plenty of risk, both on a headline basis and on the releases of economic reports. This doesn’t mean that a new bear market has started – far from it. But it does mean that the smart money (read: the big money investors) has turned more cautious, and I’m right there with them.

I anticipate that global economic activity will pick up in the 1st quarter of next year, and that the Euro Zone crisis will stabilize. I think the fundamentals of the stock markets around the globe are solid enough to support these challenges, and that they’ll grind higher as the new year unfolds.

Even though the road ahead is full of risks, I remain committed to owning stocks. The sharp correction that we had last summer and fall helped to remove some of the speculative froth from the markets. My technical indicators are showing strength, as evidenced by the healthy trends in moving averages. My fundamental indicators are also showing healthy readings, as evidenced by continuing earnings improvement, better top line growth, and improving balance sheets. This environment is friendly for equity investors, and my clients are taking maximum advantage of it. Even though the stock market has doubled over the past 3 years, stock prices are not expensive on a historical basis.

Where Are We In The Stock Market Cycle?

The stock market moves in cycles. The long term cycle is called the Secular Trend. We believe that we’re currently in the middle of a Secular Trend that began in March of 2000, with the bursting of the Tech Bubble. We told our subscribers at that time, that we were in for a long sideways move that could last 10 years or more. We now believe that this long, sideways market could last much longer than 10 years. It would not surprise us to see the stock market in the year 2020, end up at the same level it reached in March 2000. But how we get there is another story entirely. For that, we must turn to the shorter market cycles.

The Primary Trend Is Up

The long term trend (Secular Trend) is sideways. But the medium term trend (Cyclical Trend) is up. The cyclical trend can last from 1 to 3 years, and it’s very sensitive to the business cycle. When business are doing well, the stock market tends to do well. The current cyclical trend began in March of 2009, when the economy and the bear market both bottomed out after the housing bubble burst. We’re now at the end of the 2nd year of this 3 year cycle, but we believe there is more room on the upside. It would not surprise me to see the market make a new all-time high above 1565 on the S&P 500 by March 2013.

The Short Term Trend Is Up

The shortest of the cycles we follow is the 1 to 3 month trend. We don’t make any changes to our portfolio holdings based on this trend, but we do try to time any new purchases to take advantage of better prices. I expect the S&P 500 to make a push toward the 1500 level by late fall. After that, I think a pullback to the 1350 level seems likely.

Unsustainable rally in the bond market

The bond market, especially the U.S. treasury bond market, rallied as a direct result of the global “flight to safety” trade. Nervous stock market money flooded into treasury bonds, causing prices to spike higher and yields to decline. We now believe that trade is over. As market participants become more confident about the resolution of the Eurozone sovereign debt crisis, they will gradually start to drain some of that money away from bonds and put it back into riskier assets. If you are currently over-invested in bonds, we think now is a good time to lighten up. If you are nervous about stocks, you can park your bond money in cash temporarily.

Commodities under pressure

Commodities have been booming ever since the recession ended in 2009. But more recently, commodities have come under serious pressure. Oil, silver, copper have all dropped sharply in recent months. Partly due to a fear that China’s growth would slow down, and partly due to fears of a “double-dip” recession, almost all of the commodities we track were down 10%, 20% or even more in the last few months. The weakness in commodities seemed more justified to us, given the announcements by the Chinese that they are trying to moderate growth, and given the potential for slower Eurozone growth as a result of austerity measures. We think the selloff in commodities will be short-lived, and we recently increased our allocation to them. Our premium members and our coaching clients were alerted to these changes in plenty of time to take advantage of the rebound.

Currencies are being re-aligned

The dollar has rallied sharply in recent months, but longer term it continues to struggle, based primarily on the belief that the U.S. debt and deficit problems are getting worse, not better. The Euro is under trememdous pressure as investors flee from a possible sovereign default. This is an indication of fear, and in our opinion, it’s not sustainable. There may be some further weakness in the Euro, but we’re looking for an oversold bounce. And any talk of dollar-euro parity is just wild speculation based on a complete meltdown in Europe.

Pay attention to the business cycle

As always, our stance on the markets, and our asset allocation models, are driven primarily by the business cycle. As long as the cycle remains healthy, we see no reason to change anything. If the markets correct out of pure fear, we view it as an opportunity to buy underpriced assets. But if we see fresh evidence of a possible turn in the business cycle, that would be very different. If that were to happen, we would have to revisit all of our assumptions about growth and value, and we would be much more open to the idea of reducing exposure to the stock market.

“Those who wait for every problem to be solved before investing will be buying closer to the top than the bottom.” – Jeff Miller, Seeking Alpha