The Stock Market

The US stock market has been on a roll lately, with the S&P 500 index up 2.2% over the past month, and 12.5% since the low on July 17th. The only problem is there doesn't seem to me to be a legitimate reason for a 12% gain in 4 months. Consumer confidence has risen, and oil prices have dropped - so the US consumer is looking strong, but corporate earnings growth is slowing and there is a great deal of talk about the Fed cutting interest rates in 2007. Here are some excerpts from the Wall Street Journal about the market this past week:

WSJ.com: Wall Street Focus Shifts From Elections to Fed November 10, 2006.

Wall Street shifted its gaze from the fleeting turbulence of the midterm elections to more-familiar fare Friday: earnings, oil prices and the Federal Reserve.
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"The topic de jour for the next few weeks will be the Fed" and its policy meeting in early December, said Ned Riley of Riley Asset Management.
Investors will also focus on consumer spending as the holiday season ramps up. A new survey by the International Council of Shopping Centers shows consumers may cooperate. On average, consumers plan to spend $676 on holiday purchases this year, up 9% from last year, according to the survey, helped by declining gasoline prices.
Wall Street will get an important batch of economic data next week, when the government releases its monthly inflation statistics. Any hint that inflation is creeping higher will likely trigger a selloff on Wall Street, said Mr. Malone, since many investors are banking on a Fed rate cut in early 2007 to cushion the softening economy's downward slide.
Until then, stocks are likely to languish, as they did throughout Friday, though they finished the day with a push into the black. The Dow Jones Industrial Average gained 5.13 points to 12108.43, gaining 122.39 for the week.
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The Standard & Poor's 500-stock index gained 2.57 to 1380.90, and the Nasdaq Composite Index rose by 13.71 to 2389.72, its highest close since February 2001.
Oil prices fell $1.58 to $59.58 a barrel after the International Energy Agency lowered its global oil demand forecast for 2006 and 2007, citing weakening demand from China. Gold prices fell $7.50 to $629.30 an ounce after surging more than $18 Thursday after an official with the People's Bank of China said the country may diversify away from U.S. assets such as the dollar and bonds.
Treasury securities rallied after a Thursday auction of $13 billion worth of 10-year bonds showed strong demand from overseas buyers, including foreign central banks.
Though stocks have meandered in the past few days, some investors expect the uptrend that recently lifted the Dow industrials to a record high to resume. The period from November through January is traditionally the strongest of the year for stocks, and many analysts think this year will be no different.
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The reason for Mr. Pavlik's bullish stance: expectations that the economy is on solid footing and that a rate cut by the Federal Reserve in the first half of 2007 will help growth continue.
While market analysts aren't in complete agreement about why stocks tend to rally at the end of the year, one factor is the wave of spending generated by the holidays, which tends to lend a bullish tone to Wall Street. This year, investors also hope a sharp drop in energy prices will lead to a happy holidays, the most critical time of the year for the nation's retailers.

Link to the full article.

You'll notice that there was quite a bit of mention of the expected rate cuts by the Federal Reserve in 2007 in that article. That theory is part of what is driving the market higher. The problem is, if the Federal Reserve cuts interest rates there will be a reason why. The Fed does not cut rates to drive the market higher; they cut rates to spur on a slow economy or to raise prices in the face of deflation. I think at this point we can rule out the idea that we may be facing deflation as an impetus for the Fed to cut, so it would have to be because the economy is slow. If the Fed sees that the economy is slow, and reacts, generally that means it is too late and a recession is in the offing.

So to bring all these predictions back together and spell them out in simple language, the Market assumes that the economy will be slowing in 2007, probably leading to a recession, and so stocks have been rallying higher. That is not a good reason for a rally.

Now, I do also feel that there is a likely chance of a relatively strong market through mid-December based on current bullishness and the general lack of bears recently. Also, the fact that for the past several years there has been a strong rally in Q4 is good reason (in investor's minds) for there to likely be one this year.

And I think that, ladies and gentlemen, is the reason for the recent rally. Money has been flowing into the market in anticipation of a Q4 rally, which has driven the market up double digits. I think that if this rally does not materialize we could easily see a disappointing reaction. Also, I wonder how much of the money is planning on leaving the market early in Q1 2007, as they expect a slowing economy and Q2 of each of the past several years has not been a tremendous time to be invested. I think we stand to see a peak in late November or early December followed by several months of market drops, which should be a good time to be buying, particularly mega cap companies with strong fundamentals.