Can the Economy Continue to Grow Without Major Stimulus Infusion?

“Calling the Trend” Column, by George Leong, B. Comm.

These are scary times for stocks given what is developing into a steady market correction. The two growth areas of technology and small-caps are leading the decliners, with the NASDAQ and Russell 2000 down six percent and 10%, respectively, since trading at the recent highs. The DOW and S&P 500 have fared the best, down 4.38% and 5.90%, respectively. The rally looks somewhat tired and needs a fresh dose of positive news to attract buyers. In the absence of this, markets could trade sideways. It is clear that traders are nervous about the current underlying strength of the market and do not want to be caught with major positions.

In the tech area, investor sentiment has been neutral on the NASDAQ in four straight session following weeks of bullish readings. The CBOE Volatility Index (VIX) continues to be high, a potential indication of a large downward move forthcoming. We feel markets are at a critical point.

The failure of any fresh catalyst to drive buying is leading some sellers to the exits. The concern with earnings quality and a lack of revenue growth to drive earnings is a major problem going forward. The fact is that, while the third-quarter GDP was stronger than expected and growing, it was only one quarter and was largely driven by economic stimulus spending, which is coming to an end on many fronts. The question is: can the economy continue to grow without major stimulus infusion? The cash clunkers program for vehicles was a great success and largely drove retail sales, but it is over. The first-time homebuyers’ tax credit program is drawing to an end, but the Obama government is thinking of extending it to November 2010, which would be a smart move. The negative is that the cost of these programs adds to the debt and deficit, which in turn is hampering the U.S. dollar and interest in U.S. assets.

Uncertainties in the financial sector are also continuing to impact banking stocks. In the UK, there is renewed concern after news of another bailout of the Royal Bank of Scotland, which will cost taxpayers about $41.0 billion. Moreover, UBS AG announced a third-quarter loss of 542 million dollars. U.S. banks are edging lower.

There is also some concern towards the possibility of a double dip recession in 2010. Once the government’s stimulus ends, it will be interesting to see its impact on consumer spending. Consumer spending fell 0.5% in September, representing the biggest decline in nine months and down from a 1.4% rise in August. The end of some major stimulus spending is impacting consumer spending and could hit GDP growth going forward

We get a sense that markets could likely head lower in the near term in the absence of major fresh positive news. The key in this market is to monitor your positions and take some profits on the big winners. The last thing you want is to see the gains disappear.

If you are familiar with options, consider the following lower-risk strategies:

(1) Establish a Put Hedge to protect against further downside moves through the buying of put options on a stock or an index;

(2) Write some covered calls to generate some option premium income should the markets sink further or trade sideways;

(3) Bearish traders could initiate some bearish put spreads.