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MARKETS SURGE – BUT WHY?

November 07, 2010 | About:
GuruFocus

Gordon Pape

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It appears that American investors love the prospect of political gridlock in Washington and another round of dollar devaluation. How else are we to interpret the stock market surge in the wake of the mid-term elections and the move by the Federal Reserve Board to the next stage of its quantitative easing program? The Dow is in territory we haven't seen since just before it began its precipitous plunge in September 2008 following the collapse of Lehman Brothers. It's still well below its all-time high but the 50-day moving average remains in the uptrend that began about a year ago and the 200-day moving average is levelling out after a long decline.

It can be argued that the only reason the Dow has moved this high is because the index dumped big losers like Citigroup, General Motors, and AIG after those companies ran into trouble. But even the more broadly-based S&P 500 is back to its pre-Lehman levels. As for tech-heavy Nasdaq, it hasn't been this high since mid-May 2008. If it acts like a bull market and looks like a bull market, it may, in fact, be a bull market.

But is it, really? Pessimists continue to insist this is a bull rally in a protracted bear market and they could be right. There are enough uncertainties out there to cause concern. The U.S. recovery remains tentative at best and the mid-term election results make it likely that no meaningful action will be taken to tame the country's runaway deficit over the next two years. There were some conciliatory noises from both Democrats and Republicans after the results came in that raised hopes that they might be able to find common ground on at least a few issues. The most important of these is the extension of the tax cuts brought in by George W. Bush, which are due to expire at the end of this year. President Obama has been reluctant to agree to a blanket extension but now there are indications he may be ready to concede.

Wall Street is paying especially close attention because the measures include reduced tax rates on dividends and capital gains. Currently, the top rate on long-term capital gains in the U.S. is 15%. If the Bush cuts are not extended, that will rise to 20% on Jan. 1. As for dividends, the top rate of 15% would vanish and dividends earned after the first of the year would be assessed at the taxpayer's marginal rate.

The stakes are high. If the lower dividend and capital gains rates are not extended, the result could be a selling wave as investors bail out before the higher rates kick in. That would drive down U.S. markets just at the time of the usual Santa Claus rally and have a chilling effect on investor psychology.

But even with so much on the line, getting action before the end of the year (which will have to be done by the old Congress) won't be easy. American politics has never been this polarized and the ascendancy of the Tea Party faction, which helped elect several Republican candidates to the House, Senate, and state governorships, makes the whole process even more acrimonious and unwieldy.

It has been argued that a stand-off in Washington will suit U.S. investors just fine as it reduces the probability of unpleasant political surprises and provides stability for the next two years. But what passes for "stability" in the U.S. today would be completely unacceptable in Canada. The deficit is out of control, a significant minority is in a state of semi-open revolt against big government and higher taxes, people are still losing their homes, and unemployment is stuck at close to 10%.

We arrived at our winter place in Florida last Tuesday as the election results were coming in. The first news I heard from our neighbours the next morning was that the local movie theatre and a favourite restaurant had closed, the latest victims of the recession the economists insist doesn't exist. Those were small events in themselves, sure, but a sign that things are still tough in this corner of the U.S. People are angry and frustrated, as the election results showed.

Meantime, the Fed waited until after the results were in to announce that a new round of quantitative easing (QE2 as it is being called) has started which will involve the purchase of $600 billion worth of U.S. Treasury bonds over the next few months. This move is an attempt to ward off deflation, which is regarded as a serious threat in the U.S., and to encourage banks to reduce already low mortgage interest rates to ease the strain on the housing market. But, as Ryan Irvine points out in his column elsewhere in this issue, one consequence may be the creation of a new asset bubble that will cause more grief down the road.

One of the effects of QE2 that is never officially mentioned in Washington is that puts more downward pressure on the value of the U.S. dollar since quantitative easing basically amounts to turning on the presses and printing money. In response, the loonie reached par against the greenback on Friday and seems certain to move above that level in the next few weeks.

A lower U.S. dollar also means higher commodity prices, which is good for Canada's resource sector. Oil and gold both took big jumps on Thursday, with crude up US$1.80 on the day while gold surged US$27 and then added another US$14.60 on Friday to end the week just short of US$1,400.

So what does this mean in terms of your investments? For starters, it suggests the current bull market in resource stocks is not over and may have a long way to run. Energy companies, especially those with a strong oil focus, look relatively inexpensive at current levels. Some, such as Suncor, are still trading at about half their peak levels of 2008. Investors with a mid to long-term horizon should be overweight in this sector.

Gold and silver stocks also have more upside. Most of the attention has been focused on gold this year but in fact silver has significantly outperformed it. As of the close of trading on Thursday, gold was ahead 26.3% for 2010. Silver had gained 54.8%. Our recent pick, Silver Wheaton (TSX, NYSE: SLW) hit an all-time high on Friday, closing at C$32.97, US$32.95. That's up 28% (31.7% in U.S. dollar terms) from the prices on Sept. 20, when we advised buying the stock.

Looking at the U.S. market, I suggest concentrating on stocks with the potential to significantly outperform. If the loonie keep rising, as I expect it will, gains in U.S. shares will suffer some currency erosion. Prudent investors should factor in a 5% increase in the value of the Canadian dollar in the next few months, to the US$1.05 range. That suggests you should avoid any U.S. stock that does not have a one-year upside potential of at least 20%. Some Buy suggestions from our Recommended List: Cisco Systems (CSCO), Intel (NTC), Johnson Controls (JCI), OSI Systems (OSIS), and ProShares Basic Materials ETF (UYM).

Bonds are likely to underperform in 2011 but don't abandon them. They should always be a core holding in a portfolio and they provide an essential safety valve if stocks go into another tailspin. Limit the risk by staying short-term (maturities of no more than five years), either with funds or individual debt securities.

The euphoria we saw in the markets this week was welcome, but the underpinnings remain shaky. This is not a time to throw caution to the winds and plunge in over your head. If you have big gains and some capital losses to write them off against, you might consider taking a little money off the table and building cash reserves in preparation for the next correction. If the U.S. does not extend the Bush tax cuts beyond the end of this year, that could come sooner than expected.

About the author:

Gordon Pape
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 2.4/5 (12 votes)

Comments

halis
Halis - 3 years ago
Bonds are likely to underperform in 2011 but don't abandon them. They should always be a core holding in a portfolio and they provide an essential safety valve if stocks go into another tailspin. Limit the risk by staying short-term (maturities of no more than five years), either with funds or individual debt securities.

IMO this is terrible advice. If bonds are likely to underperform, because they have pitiful yields and no margin of safety, then by all means, abandon them.

The idea that they should always be in a portfolio is, quite frankly, stupid. If you think bonds are "safe" then I think you should do some homework. If various events take place, the price of bonds can trade substantially lower than current levels, resulting in a choice between permanent loss of principle or receiving an extremely low yield until maturity.

Staying in medium term bonds with a maturity of 5 years would be the only sensible thing you said if bonds weren't such a terrible idea right now.

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