Can the stock market continue to go up in the face of all the negative news and seemingly dismal prospects? Stocks got off to a strong start in the first quarter, advancing by 13%, only to experience a correction of 11% between April and June as investors worried that the European debt crisis was being badly managed. The market had a late summer rally sparked by ECB President Mario Draghi’s pledge on July 26 that “he will do whatever it takes” to save the euro. The ECB said it would undertake a bond-buying program without limitation that would avoid defaults and make it easier for troubled countries to issue new bonds. Europe is in a recession, but the ECB has averted a crisis flash point. The basic problems still remain, but this was encouraging news and markets have responded positively with higher bond and stock prices.
In the U.S. the Federal Reserve defends its quantitative easing programs that got us through the financial crisis and contributed to the economic recovery. At its most recent meeting of the Federal Open Market Committee it expressed concern about the chronic high unemployment rate and slow growth. It announced a new program to buy $40 billion of mortgage-backed securities a month indefinitely to stimulate the housing market, bring down mortgage rates and reduce unemployment.
There are encouraging signs that the U.S. economy may be experiencing stronger growth with the improvement reported in consumer confidence, retail sales, housing, and employment.
Investors are worried about the vulnerability and volatility of stocks and have continued to reduce their holdings of equity mutual funds and are shifting more of their money into bond funds. Investors have to believe the Fed’s repeated statements that they intend to keep interest rates low until 2015 or even longer. At some point they will likely become disenchanted with these historically low yields. In addition, there is now $10 trillion in cash and money market funds earning nothing that should have an incentive to seek higher income and growth in other real assets and stocks.
Investor focus on the negatives is understandable with the incessant media blitz on the weaker economy, slower earnings growth, election year politics, the “fiscal cliff” and the prospect for higher taxes. Since business is not recovering at a rapid pace, the current expansion should be sustainable for several years into the future. While earnings prospects have been revised down, they are still rising. Stocks are under-owned in most portfolios and, with low expectations, they are fairly priced. If growth continues, even at a slow pace, stocks are undervalued.
The objective in investing is to achieve income, growth and capital preservation in real terms, adjusted for inflation. To accomplish this objective, most investors have to allocate a significant portion of their assets to higher risk assets, as appropriate for their situation, and invest for the long term.
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