As of the close this past Wednesday, the stock market as represented by the S&P 500 (the largest 500 publicly traded companies domiciled in the United States) has doubled from its ominous-sounding intraday low of 666.79 set on March 6, 2009. With this in mind, rather than focus on how much higher this index might be able to go from here, a prudent investor is asking his/herself what could derail this upward momentum. As prudent investors, our response detailed below.
First and foremost, the catalyst for the recovery that we have witnessed initially in the stock market and subsequently in the U.S. economy can be directly attributed to trillions of dollars of stimulus from the Treasury Department as well as the Federal Reserve in the form of a reduction in interest rates, taxes and two rounds of quantitative easing. The hope is that this “kindling” will be enough to light a lasting fire under the economy, one that won’t go out after this “kindling” either is removed or runs out. To date, this stimulus has been relatively effective, but, in our opinion, temporary in nature and temporary in its impact.
With Unemployment hovering around nine percent and down from a multi-decade high of over ten percent, a substantial change in the direction of the recently improving labor market could derail this stock market by dimming the optimism currently shared by businesses and consumers and result in a reduction in spending on both fronts. For businesses, this would mean a curtailment in the addition of employees and reduction in capital investment. For individuals, this would imply a reduction in discretionary spending as well as a reduction in spending on big ticket items like homes, cars and appliances. Keep an eye on the job market.
A second potential catalyst for some serious downside to stocks could be a second leg downward in the housing market. As is well documented, from mid-2003 through mid-2008 home ownership in the United States climbed from an historically normal low-sixty percent range to the mid to upper sixty percent range as banks and other financial institutions such as government agencies Fannie Mae and Freddie Mac eased lending standards and then packaged those loans to unsuspecting investors. The result was a near cataclysmic drop of more than 30% in housing prices nationwide which ran concurrently with a severe economic slowdown which, as a nation, we are still emerging from. At the present time housing demand remains tepid despite the historically low mortgage rates, rates which are slowly helping new homeowners soak up the excess inventory from overbuilding. Should this demand weaken substantially, the entire U.S. Economy would also weaken placing this recovery in jeopardy. Watch the housing market.
Rising commodity prices that may eventually cause inflation or worse stagflation is a cause for concern. Food costs have risen 0.5% over the past month at the retail level while geo-political tensions in the Middle East as well as strong demand from the BRIC (Brazil, Russia, India, China) Countries have fueled higher energy costs. The result is that consumers have less discretionary dollars in their pockets and businesses have become a bit cautious. Watch food costs. Watch what you pay at the pump.
Keep an eye on the politicians. While researching the historical returns of the stock market over the past century or so we found that stocks during the third year of a Presidential Election Cycle (calendar year 2011) outperform the other three years by about a two-to-one ratio. Furthermore, during the first six months of this third year stock investors reap almost their entire gains for the year. After that, stocks historically move sideways until the Presidential Election, November 2012. The reason is clear. As the election season draws near, the political rhetoric and divisiveness grows thereby dimming the optimism of most Americans. Listen to the news. Listen to the rhetoric. See if the Democrats and Republicans continue to play nicely together or begin swinging at each other.
THE BOTTOM LINE – We’ve had a nice rally off the lows. Time will tell whether this was a short-term, cyclical rally or the beginning of a longer-term, secular move. By paying attention to the job market, the housing market, commodity prices and our elected officials you may find a chair should the music stop.