A Look at Recent Stock Rallies

August 20, 2012

Why have stocks been rallying in the face of indifferent economic news? Some observers point to 1980, when poor economic conditions (high unemployment plus inflation) were met with stock strength.
-Frank James, founder, James Investment Research


Stocks rose last week, with almost 2000 advancing against about 1,150 declining. Nearly 360 stocks set new highs against only 50 new lows. Volume was relatively low on most trading days, however highest toward the end of the week when prices were rising. Most major stock averages were ahead for the week, except for utilities, which lost more than 1%. The broad Russell 3000 index was ahead about 1%. Commodity prices were somewhat higher, except for wheat and a few industrial metals such as zinc, lead, and aluminum. This contrasted with consumer prices, which were reported as ahead a moderate 1.4% year over year.

The rally in stock prices continues to have support, however it is long in tooth. Thus stock averages move higher but the bulk of the securities have begun to lag. Today 8 out of 10 SP 500 stocks are above their 50 day moving average, and 71% are above their 200 day moving average. These are indicators of excessive enthusiasm. Investors Intelligence surveys support this view, with now 44% bulls against only 27% bears. The VIX "fear gage" also shows excessive complacency, with a reading of only 14.3. The five year range of the "fear gage" is 13 to 103, we are today within 1 point of the five year low!!!

Recently larger stocks outperform smaller ones, now seen by the 2% outperformance of larger stocks. Dividend paying stocks have also done well, along with importers (not exporters) which did better by an average of 6% year to date. Domestic issues have outperformed foreign stocks by about 7% for the year to date.

The rally in the stock market appears to have been sparked by developments in Europe. While the head of the European Central Bank talks of resolution of their problems, his authority to print euros and buy bonds is still circumscribed. In spite of two massive loan packages, the unemployment rate in Greece has increased to 23.1%. High unemployment is also seen in Spain, and in Spanish banks, almost 10% of loans are nonperforming. Funds continue to pour out of Europe and many seek refuge in the U.S..

Month over month, housing starts reflected a 1% decline; however, building permits were strong. Both the New York and Philadelphia Fed reports of economic expectations turned negative.

To remedy defects in U.S. economic activity, TV reports the President may be allocating some $2 or $3 billion for Congressional preference projects, and instead spend this on roads and bridges. This may or may not be appropriate, but we have little hope that stimulus spending will be greatly effective. A recent report by Laffer confirms earlier studies by the International Monetary Fund (IMF) that among the 34 ODEC countries, those that "stimulated the most" from 2007 to 2009 saw the least growth in subsequent periods. It just stands to reason-if one could make him or herself prosperous by borrowing and spending, the path to wealth would be easy.

The three month period before Presidential elections is said to forecast the success of incumbent parties in getting reelected. We measured changes in the stock market since 1928, but did not find this metric to be especially helpful. 86% of the time voters "stayed with" the party then in office, and changed only 14% of the time. Two thirds of the time periods were positive, which is to say stock prices rose in the final months before election. One third of the occurrences were negative, which said that prices fell just before the election. Rising or falling, the party then in power retained the White House with an 86% probability. It is worth noting that the worst three month period, August through October, occurred in 2008 when stocks fell almost 24%. And, a change was made. Also, that poll approval ratings are correlated with votes on Election day. President Obama, according to the last Gallup poll, has a 45% approval rating. Disapproval ratings are said to be correlated with stock market performance. Again, according to Gallup, President Obama has a 49% disapproval rating (latest survey Aug 6 to 12th).

Why have stocks been rallying in the face of indifferent economic news? Some observers point to 1980, when poor economic conditions (high unemployment plus inflation) were met with stock strength. The 1980 rally began about l week before Ronald Reagan was formally nominated to be President, which heartened conservative investors who correctly forecast victory.

Our leading indicators continue to trend unfavorable. We suggest investing with caution in this environment.