Following Ben Bernanke's first strong hints in late August that the U.S. Federal Reserve would indulge in another round of unconventional economic stimulus, we saw some wild movements in market positioning across a variety of asset classes. Right now, there is still an extreme level of speculative activity that is set to unwind as the appetite for risk fades away.
Over the next few months, I expect the S&P 500 to trade down to around 1,000, the low end of its 14-month range. I also expect a falloff in commodity prices, although I remain bullish for the long run on this area. Finally, I think long U.S. bonds - those with terms of more than 10 years - are ripe for a rally, especially seeing how high the yield gap is between those bonds and five- to 10-year Treasuries.
All of this is to be expected as problems with the bullish consensus of the past few months become apparent. While some of the economic data in the U.S. have looked a little better in recent weeks, there is still a list of lingering concerns, as demonstrated by the outbreak of discord in so many areas.
There is discord within the Federal Reserve about the merits of quantitative easing, discord within Congress about extending the Bush-era tax cuts, discord at the G20 about global trade imbalances, and discord within the euro area about the possibility of bailing out Ireland and other financially strapped countries.
On top of the discord, there is also this issue of China feeling compelled to fight a food-led inflation surge by tightening monetary policy. This, in particular, has unfavorable implications for commodity prices.
U.S. consumer confidence remains weak, as well. This past week, the University of Michigan consumer sentiment index ticked up to 69.3 from 67.7 a month earlier. But while the headlines screamed that confidence was at a five-month high, the index is far below the levels common in economic expansions (99) and even below the level that is generally seen in recessions (74).
Spending on Luxuries
One interesting development in the data is the divergence between low- and high-income households. Confidence remains low among low-income households (65), but is much more positive among high-income families (77.3).
This tends to support the view that luxury retail sales will perform well in the holiday shopping season. There is an 82-per-cent correlation between the stock market and high-end retail sales, such as jewellery.
But can the stock market keep going up? Sentiment has reached extreme levels of bullishness - usually an indicator that a market downturn is on the horizon. The Investors Intelligence poll shows there are now twice as many bulls as there are bears among U.S. investors. The Barron's magazine Big Money poll of portfolio managers reveals 62 per cent bullishness toward stocks. All of these are signs the stock market is overextended and ripe for a correction.
Many of the fundamental pillars of the bullish view are now being reassessed. Take, for instance, the belief that the second round of quantitative easing - QE2 - would be followed by additional rounds as needed. That now seems unlikely given the dissension within the Federal Reserve.
Kevin Warsh, one of the Federal Reserve governors, has basically come out and said he only supported Mr. Bernanke's plan for QE2 because he wanted to be seen as a team player. Tom Hoenig, another governor, is already opposed to quantitative easing. All of this suggests that any further attempts to expand the Fed's balance sheet will be met with dissent.
The speculative froth of the past few months is slowly fading and risk-taking fervour is cooling off as the market prices out the chance that QE3 will ever see the light of day. Investors should be cautious about the areas where speculators have been most active and are in the act of unwinding their positions. That includes stocks, the euro, copper and gold.
David Rosenberg