Reflation = S&P 1000; What’s Next?

Good Evening: U.S. stocks once again surged ahead on Monday, leaving the widely watched S&P 500 above 1000 for the first time since last autumn’s precipitous fall. Leading the way were the economically sensitive materials, energy, and industrial names, which themselves were the beneficiaries of a strong tailwind in the commodity pits. As soon as China’s PMI logged its 5th consecutive reading above the 50 mark last Friday morning, natural resource firms around the world have outperformed. This morning’s economic data in the U.S. only added to the momentum behind these resource plays, and today’s proceedings left the S&P up more than 50% since the March lows. Such a prodigious climb in less five months is a quite the achievement for a broad market index. It leaves open only one little question: Where to from here?

Overseas markets were higher overnight, as Asian markets continued to bask in the afterglow of last week’s positive Chinese PMI reading (see below). European markets were also firm in the wake of better than expected earnings announcements from both Barclay’s and HSBC. U.S. stock market futures were some 1% higher prior to the open, and those gains were extended when Monday’s economic data hit the tape (see below). The national ISM survey posted an upside surprise, coming in just below 50, the fulcrum level between expansion and contraction in the manufacturing sector. Construction spending likewise exceeded consensus expectations, but it was the auto sales data that set tongues a wagging. Aided by the “Cash for Clunkers” program (which was oversubscribed in less than one bureaucratically administered week), auto sales were up for what seemed like the first time since the onset of the Great Recession. Ford’s 2.3% gain, for example, was the first uptick for the last U.S. automaker standing since 2007.

Stocks leapt as these data points were revealed, doubling the early gains of 0.5% to 1%. Once the S&P vaulted into 4 digit territory, however, market participants backed off a bit to see if the market could maintain those early gains. The averages traded mostly sideways for the rest of the session, though some late buying left the indexes near their best levels of the day. Reflation and beneficiaries of Chinese demand were the dominant themes, as the averages advanced between 1.25% (Dow) and 2.65% (Dow Transports). Historically, Treasurys have embraced anything having to do with the words recession and deflation. But add “re” to “flation” and you have a word that keeps bond investors up at night. Spying this less than welcome word in the press more than once today, Treasury market participants marked up bond yields between 7 and 16 bps. 5’s, 7’s, and 10’s bore the brunt of the selling. The dollar was also weak, losing a further 1% today, and commodities again soared in response. Crude oil climbed back into the low 70’s, grains roared ahead, and even the metals did their part as the CRB index rose almost 3.5%.

Back on January 2, I decided to hazard a few guesses about 2009. About the S&P 500, I said it might “trade in a wide range. Upper end for S&P is 1000 to 1100, while there is a better than 50/50 chance we see the November 2008 low of 741 taken out in 2009”. Honestly, I thought the rally to 1000 would come first, offering up a four digit welcome mat to the newly elected President, Barack Obama. I thought the reality of a faltering economy and souring loan portfolios would then snap investors back to reality, but while both ends of this forecast have (as of today) now come true, I got the timing exactly backwards. Whereas investors believed back in March that policy actions taken to revive the financial system were too little and too late, here in the first week of August some are even talking about welcoming Goldilocks back to her former perch at the corner of Wall and Broad.

Swinging from optimism to pessimism and back again is old hat for Mr. Market. Just when investors think they know which direction the old geezer is headed, he often — and inconveniently — does an about face. After plunging to the depths just as this past winter was ending, U.S. equities rose with the first green shoots of spring. Now up more than 50% since those harrowing days 5 months ago, many now claim stocks are headed another 10% to 20% higher before the calendar says 2010. Mr. Market doesn’t even look winded. Of course, he looked every bit as spry to NASDAQ investors twice during the crackup, only to later fall over and set new lows. And, in perhaps his most legendary pump-fake of all time, Mr. Market fooled even the most experienced professionals after the Great Crash in 1929.

As you will see by clicking on the final link below, the Dow dropped from a 1929 high of 381.17 to 198.69 after “Black Tuesday”. Sensing a washout that had purged the market of its sins and populated the tape with astonishing values, the professionals snapped up the bargains the public had left like litter on the NYSE trading floor. By the following April, the Dow had clawed its way back to 294.07, a gain of nearly 50% in just less than six glorious months. Unfortunately, the TARP-less Dow then trapped an entire generation of bargain hunters when it then dropped to 41.22 by 1932.

I relate this old tale (akin to a ghost story for asset managers) not to say something similar is about to befall post-millennial bargain hunters. The advent of the digital age allows the Federal Reserve to create a trillion or two with a few keystrokes, and its Great Depression-phobic Chairman, Ben Bernanke, will move mountains (of money) to prevent another depression. I write about the 1929-30 experience as a warning to those whose great grandfathers thought they, too, had nothing to worry about by buying stocks after a huge decline. They were quite sure of themselves, these long ago contrarians, and yet they were quite fooled by what was to come next.

We may not make the same mistakes made 8 decades ago, but that does not imply we will not make some of our own. I guess it’s possible that the alchemists at the Fed have found a way to turn paper into gold and that it’s onward and upward from here for both our economy and markets — but I doubt it. As for what comes next, I honestly don’t know. The one thing I do know is that marching into a cable T.V. studio and telling viewers exactly what will happen next is foolhardy. Foresight is a rare commodity in this environment, and even hindsight can play tricks on us.

For evidence I submit the action in the S&P 500 during the week AFTER Lehman failed. On Friday September 12, the last trading day before the nerve-fraying announcement that LEH would file for bankruptcy protection, the SPX closed at 1252. So, take a guess: Where did the SPX close on the following Friday — after the Lehman earthquake sent tremors around the globe? How much of your life savings would you put on the line — even with the full benefit of hindsight! — if I gave you even money odds on the simple, binary choice of higher or lower? The correct answer is “higher”. The S&P 500 closed at 1255 on September 19, 2008. If you don’t believe me, you can look it up. Mr. Market can throw you for a loop even when you know how the story turns out. What happened to those who bought stocks in early 1930, as well as to those who bought in because they thought Lehman’s failure marked the panic lows, should teach us to be a little more humble when it comes to investing. If not, Mr. Market has a way of teaching us this lesson the hard way.

— Jack McHugh

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