Are the Markets up for a Dose of Reality?

As we close in on historic highs in the US financial markets one has to wonder how much of this rally is predicated on robust economic prospects and how much is the result of FED funding? As usual there is an abundance of views ranging from very bullish to outright bearishness. Depends on what you want to focus on!

Unemployment remains stubbornly high and economic growth is moribund. On the other hand, North American companies are reporting better than expected earnings, good margins and historically high cash reserves.

The bulls have been focusing on that story. They argue that should North American companies return some of that cash to shareholders in the form of increased dividends or buybacks it will be positive for stocks. Even without that the bulls contend that the market is a leading indicator and that solid profits are the best indicator of strong demand which will eventually show up in the economic stats.

The bulls also have history on their side. Robust January rallies often lay a foundation that propels the markets higher through the remainder of the year. In fact some of the best years in the US markets began with a strong January.

The bears point to the lackluster performance of the economy and argue that much of the bulls’ case is priced into the market. Further gains will be the result of momentum buying fueled by a financial media that continues to provide a blow by blow account of the markets’ march to all-time highs!

The other worry is that small investors seem to be returning to equities. Last week’s data from the US Funds Institutes indicated that for the first time in recent memory equity funds had net inflows while bond funds experienced net outflows. Small investors buying into a momentum driven rally can be a toxic combination that rarely ends well.

The bears also believe that option volatility indices are raising a red flag. Low volatility indicates complacency which can be disconcerting as markets near an all-time high.

One consideration that has garnered little attention is the performance of the Canadian equity markets. Canadian stocks have done well in an ultra-low interest rate environment. But the S&P/TSX composite index (Friday’s close 12,768.83) is nowhere near a record high. The all-time high, recorded on June 18th 2008, was 15,073.10.

Is the Canadian market a better proxy for the real economy? I think it might be since Canadian stats are not obscured by central bank largesse and political actions. The valuations are reflecting what is actually happening in the private sector. Whether that reflection is accurate time will tell.

Obviously there is no conclusive evidence that supports either the bulls or the bears. Just conjecture backed up by subjective analysis! Generally when there is no real conviction, markets continue on the path of least resistance which in this case, would favor the bulls! At least until the US market eclipses the all-time high. After that all bets are off!

Given the risks you might consider buying some insurance. With an insurance package you can maintain long positions should the market continue to new heights while hedging against the downside should momentum change.

Certainly with volatility contracting the insurance is relatively inexpensive. To that point, buying iShares S&P TSX 60 (symbol XIU, Friday’s close $18.45) April 18 puts at 30 cents will provide some cover should a bearish scenario play out.