Sitting Here In Limbo

Author: Eric Linser, Green Valley Wealth Advisors

Covestor model: Eagle Portfolio

We got more tricks than treats on the Halloween trading day and continuing into All Saints' Day, but for all of October we got lots of treats — US stocks were up very sharply after the S&P 500 made a 13 month low on the first trading day of the month. October turned out to be the biggest monthly advance since 1991 for the S&P 500 and 2002 for the Dow, and we also snapped a five month losing streak for the S&P.

The Halloween indicator is flashing orange, black, and well, green. The Halloween indicator is the opposite of the adage (or curse) of “Come May, Go Away” and come back sometime around Halloween, as historically the best performing months are November through April.

This year we jumped the gun on the Halloween indicator as investors came back a few weeks earlier than expected. The whole premise is pretty simple, but it's worked this year and last. Obviously such a simple timing process excludes taxes and trading costs and has a rather doubtful basis (no rational decision making), but it's fascinating how well it's worked as of late.

Dia de los Muertos
The day of the dead – an apt description for Greece. Like a ghost, this seemingly inconsequential country comes back to haunt us and spook the markets.

We have vacillated between despair and excitement that European policymakers get it and that a credible strategy will address their myriad of problems and restore confidence.

It seems like we've been fixated on Greece and Europe for the past 1 ½ years and understandably so, given the systematic risks that the region represents to the global economy and financial markets. The European Union (EU) represents about 25% of global GDP, roughly equivalent to that of the US.

European leaders cajoled Greek bondholders (mostly European banks) into accepting a 50% write-down on their holdings. Will it be enough? Probably not. That's why they boosted the European rescue fund's capability to $1 trillion euros (US $1.4 trillion) and are asking the International Monetary Fund (IMF) to increase funding. The objectives are to protect the euro currency, keep Greece in the EU, and ring-fence Italy and Spain from further financial contagion.

But wait…now it appears the Greek populace will vote on a referendum to stay in the EU or not. No, wait…no referendum but a new government to renegotiate the EU bailout package. Wow! It amazes me how much sway Greece holds over the ongoing viability of the Eurozone with possibly severe financial implications hanging in the balance for the region and the global markets.

There were finally some (brief) moments in late October that European leaders were progressing towards negotiating a viable rescue plan to ensure stability in their financially fragile currency union. Investors came rushing back in and global stock indices soared, bolstered by bullish corporate earnings here at home coupled with encouraging developments in the Eurozone.

Add it all up and it's quite evident why we continue to trade in a fairly tight trading range since early August, and why stock shares have pushed back from the top end of the range after just recently breaking out.

Focus on the Home Front
In October it appeared we were finally starting to focus on other catalysts for the capital markets to move higher – US economic fundamentals and corporate earnings, not the daily headlines of Europe's debt problems.

Surprising to most, American economic growth actually accelerated in the 3rd quarter. In late October we received the government's report on 3rd quarter gross domestic product (GDP), the value of all goods and services produced. Real GDP rose at a 2.5% annualized rate, up from 1.3% in the 2nd quarter. GDP grew at the fastest pace in a year as gains in consumer spending and business investment helped support a recovery on the brink of faltering. The report confirms the more favorable domestic economic readings of the past few weeks and tones down some of the exaggerated recessionary fears.

Market Fundamentals
Valuations look pretty attractive, earnings expectations are starting to become more realistic and credit conditions have improved dramatically from the beginning of October. We've come a long way in a short period of time. Positive economic surprises (especially for those anticipating a double dip recession), incremental progress in Europe (fingers crossed), and good earnings reports have helped to nurture a relief rally in risk assets such as domestic and global stocks and corporate bonds/debt obligations of various quality.

While there will always be a fair amount of uncertainty, I believe strengthening confidence in a US recovery will spur global economic recovery. Slowly but surely, investors will gradually reallocate capital back into risk assets. I assess valuations as very low relative to historical measures, and you don't have to make outrageous assumptions on multiples to get reasonable returns over the next year or two.

Looking to 2012
Time will tell how global economic growth pans out for next year; so far it's stunted but still positive. It appears that we'll avoid a dreaded double-dip recession and the corresponding decline in profits that come. Seeing as valuations have been reined in considerably over the summer on the possibility of a poor showing in corporate results, the market has a strong potential to rally from here, particularly on any positive surprises.

Part 2 of the Financial Crisis
This isn't 2008 all over again; this is the second act. The sovereign debt crisis is a manifestation that grew out of it; here in the US, municipal budgets are equally stressed. This is continuation of a painfully slow deleveraging process we're all feeling. This isn't a new problem, and it will get resolved.

The only thing that reminds me of 2008 is a correlation of all financial assets moving in lock-step. When investors leave an asset class (risk off), they often don't distinguish between holdings; they head for the exit. Some investors are forced to exit in a Minsky moment, while others do so voluntarily. Suddenly long term growth prospects of emerging Asian and South American economies fall on deaf ears; feeding and fueling a world populace of 7 billion quickly seems of lesser importance.

One of the facets of economic globalization is the growing integration of financial markets. It's like the adage “When America sneezes, the world catches cold”, but it now goes both ways. Sometimes the extent and complexity of global financial integration remains hard to identify and to quantify, either for the layperson or a professional money manager.

Additionally it's hard to quantify the political theatrics occupying Washington and Europe. Policymakers seem incapable of working together. They are paralyzed (polarized?) at a time when we need them to act decisively to lead our economies on the road to recovery. For now, I won't go into the work that the Congressional super committee must do to cut $1.2+ trillion from our federal government's debt load over the next 10 years, cuts that must OK'd by year-end.

As Jimmy Cliff sings, “I'm sitting here in limbo.” Things aren't getting worse and things don't appear to be improving at a fast enough pace for most of us to get excited either. The uncertainty of resolution on many fronts has meant that we're waiting for something to give.

Changing Seasons Ahead
Given one of the most challenging and polarized environments I've witnessed over the course of my career so far, I believe the most prudent course to investing is to find an adequate balance of growth, income and capital preservation knowing the solutions to what ails us won't come suddenly or easily.

We do, however, need to stay in the game. I know it's tempting to bail out given the heightened volatility and downside risks that remain, but attempting to time the market is a fool's errand. You wind up getting skinned twice, once on the way down and again when you're on the sidelines and get left behind when the market ultimately moves back up, which it always has – over longer periods. Historical data suggests a bull market is in the offing for stocks, but investors have to have confidence and courage to take advantage of the current situation.

For now, investors remain too pessimistic, meaning the rally will continue as they change their mind. As long as there's money on the sidelines, the rally is apt to continue. As I like to say, Mr. Market always does the opposite of what's expected.

2 years ago I shared a chart that outlined the 4 Stages of a Typical Secular Bear Market and Its Aftermath. I show it again below, and overlay actual results so you can see how it's tracking.

What the charts imply is that there are long periods of going sideways and that the payoff for perseverance in staying invested is rewarded in time.

With interest rates extremely low, CDs and Treasury bond yields are incapable of meeting the vast majority of retirement needs. Using the Rule of 72, it would take nearly 36 years to double your money in an investment returning 2% annually, such as a 10 year Treasury bond. I see no path to secure retirement for people other than investing in a diversified portfolio that contains a healthy allocation to stocks over the long term. To garner the money you'll need later in life, put funds aside frequently and start early!

There will always be near-term concerns and unexpected events that can distract us from our long term objectives. But despite these unforeseen events, economies have grown, companies have prospered, stock markets have generated positive returns, and ultimately we've always found our way forward. As Winston Churchill said, “You can always count on Americans to do the right thing, after they've tried everything else.”

Wishing you good health, wealth and success.

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