“The strangest market rally on record”?

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Considering that the U.S. economy grew at an anaemic 1.7 percent in the second quarter, the unemployment rate sits stubbornly still in excess of 8% and that the current rate of monthly job creation is only a fraction of the monthly hires needed to bring the unemployment rate back to pre-crisis levels by 2015 then the stock market hitting multi-year highs seems to have a lot of commentators in a lather.

With the uncertainty of a presidential election that looks potentially to go either way and also whether Congress and the president will reach an agreement to avert the so-called fiscal cliff—the spending cuts and tax hikes that could stall the US economy next year this strength seems to many even more perplexing.  Finally, throw into the mix, Europe’s financial crisis which is still unresolved and heads are being scratched all round…

In the face of all that the S&P 500-stock index is up 25 percent over the past 12 months, and 14 percent in 2012. Stocks have reached levels unseen since before the fall of Lehman Brothers and Bear Stearns. “This is about the strangest market environment I’ve ever seen,” says Donald Luskin, chief investment officer at Trend Macrolytics.

There are however some strong forces propelling the rally. Over the long term, stock prices tend to reflect corporate earnings. While S&P 500 profits may decline 1.8 percent this quarter, according to estimates compiled by Bloomberg, they will rebound 11 percent in the final three months of the year, 11 percent next year, and 12 percent in 2014, reaching record levels with every gain.

Investors are also expecting further stimulus from the Federal Reserve, potentially at tomorrows FOMC meeting where a third round of bond purchases to boost the economy may be unveiled. “The Fed has come out and said that things are weakening and that they’re willing to act,” says Gregory Peterson, director of investment research at Ballentine Partners. Also, it must be remembered that Apple’s stock price which is up 64 percent YTD is having an outsized impact on the indices. With a market value of $620 billion, Apple represents 4.8 percent of the S&P 500 and close to 13 percent of the Nasdaq Composite Index, which has surged to a 12-year high. .

Impressive though that may be, the threats to the market are formidable. Chief among them is the so called fiscal cliff and which we cover in the forthcoming edition of our magazine. Under a law passed last year in the heat of Washington’s debt-ceiling impasse, the failure of lawmakers to agree on some combination of spending cuts and tax increases could result in $1.2 trillion of automatic cuts and accompanying tax hikes in January 2013. That combination could shave 2.9 percent off economic activity in the first half of 2013, according to the Congressional Budget Office – something that Bernanke no doubt has his eye on. “These are significant risks that the market, in our view, hasn’t really appreciated,” said Goldman Sachs chief U.S. equity strategist David Kostin at a Sept. 10 conference. Luskin says that even if you assume there’s a 75 percent chance a deal will be struck, that means “25 percent of the time we sail off the cliff and into recession. Would you get on a plane if the pilot told you there was a 25 percent chance it would crash?”

Europe also remains a potent threat, what with Athens having yet to ratify the spending cuts necessary to receive life-or-death bailout funds—and no guarantee that Spain, already reeling from 25 percent unemployment, will agree to more austerity in exchange for the European Central Bank’s financial aid.

There is one wild card that could keep driving the market higher however and that is that hedge funds that through the leverage they take on have a disporportionate impact on the market, have woefully missed out on this rally. From the start of the year through to the end of August, the main Bloomberg hedge fund index gained 0.5 percent, compared with 13 percent for the S&P 500. “Hedge funds must be sitting on large cash positions or have outsized short positions—how else to explain their underperformance?” says Jenny Van Leeuwen Harrington, chief executive officer and portfolio manager of Gilman Hill Asset Management. High-priced money managers obviously don’t want to finish the year lagging the market by such a wide gap. If they capitulate and pile into stocks in a bid to catch up, that belated buying could send indexes even higher – at which point that’s our queue to get out as we have been long equities right through the summer and as our blog posts pay testimony to.

Individual investors could also decide to get with the program. They pulled money from U.S. equity mutual funds for a fifth straight year in 2011, the longest streak in data going back to 1984, according to the Investment Company Institute. So far this year, they’ve yanked $75 billion. As ever and true to form, their timing has been atrocious.

So just why have equities continued to rise? The answer to us is relatively simple – there is just no other asset class that offers an alternate home for capital on anything other than an immediate term basis. Decent blue chips with well covered cash rich balance sheets still yield 4% + around the globe while bonds are, to use well into the 11th hour of the wily coyote/roadrunner sketch – running on empty over the cliff! Add the additional winds of a new round of monetary debasement that seems imminent and to us, equities are a one way ticket with Japan, Spain & Italy our favourite picks.

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