Market Melt-up

Yesterday, the Fed announced QE3, a new round of “quantitative easing” designed to help the economy.  Many analysts didn’t expect Fed to act before the November elections, so this move was somewhat of surprise.  The markets loved it, and the major indexes, after advancing steadily during summer, are now sitting at nearly five year highs.

Given anemic U.S. economic growth, stubbornly high unemployment, recession in Europe and slowdown in China, is that surprising?  I don’t think so.  Despite the rally, S&P 500 is still 7% below 2007 high, yet company earnings that ultimately drive equity prices, are now 20% higher than they were at the market top.  On a valuation basis, excluding the 2008-09 collapse, equities are at lowest level in twenty years.  Indeed, we had quite a good run this year, but the markets really haven’t moved anywhere (excluding roller-coaster in between) for the last five years.  And going back even further, we are now at the level of 2000, 12 years ago.  So this is all a matter of perspective.

On a CNN Money site yesterday, I saw two headlines right next to each other.  One addressed the market rally, and another stated that investors moved $70 billion out of equity funds in 2012.  A week ago, an article in USA Today pointed out to piles of cash sitting on the sidelines, which was a subject of my previous post.  Of course, there are risks going forward, and a correction here will not be all that surprising.  However, headlines like the ones above give me more confidence in the longer term.  Market tops usually happen when investors move their cash into stock funds, and when your taxi driver asks for stock tips.  We are nowhere near that right now.

The Age of Safety

This was part of the title of today’s USA Today article in the business section.  Basically, the article points out to an apparent shift in the risk aversion behavior of investors: namely, fear and not greed is now the main emotion driving investment decisions.  Indeed, a record amount – $9.43 trillion – now sits in money market funds, getting a very safe return of 0%.  Investors keep taking the money out of stock funds and moving it into perceived safety of bond funds and savings accounts.  The percentage of assets invested in financial markets dropped from 76% in 2007 to just 44% today.  All that is not too surprising, giving the fact that the stock market experienced two nearly 50% drops in the last decade.

So, is this the “new normal”?  Has the lost decade permanently changed investor psychology to seek safer havens?  I think that this will be the case for the next several months or even years  — indeed, there are many immediate threats to global economy and to financial markets.  European debt crisis has not been resolved.  Chinese economy is decelerating.  Here at home, there is a danger of “fiscal cliff”.  Longer term, however, it is a safe bet that risk-taking will return.  Such widespread caution and pessimism, as well as news articles like this typically signal market bottoms.  Sooner or later, all those investors on the sidelines now will get frustrated with zero returns, and will move back into the rising market.  But by that time, most of the gains will probably have been made.