I would not be surprised at all if the stock market experienced some solid upside over the next several months. Market sentiment is improving and you can see this reflected in the spot price of oil and improving spot price action in gold. Being an election year, it often pays to be on the long side of the stock market.
But, while market sentiment is improving currently, investment risk in equities remains very high. The sovereign debt crisis in Europe is not over; it’s only begun to be addressed by eurozone policymakers. And the real crisis, in my view, consists of the sugarcoating economic policies in both Europe and the U.S. The debt crisis is actually being addressed with more debt and easy money. Austerity is happening, but it isn’t enough. How have eurozone policymakers addressed their sovereign debt crisis so far? By issuing more debt that’s referred to as a “bailout.” The same thing happened during the U.S. subprime mortgage meltdown and similarly today with artificially low interest rates and a massive increase in the M2 money supply. These policies are designed to help in the short term, but will be detrimental in the longer term.
This is why stock market sentiment is improving right now and why the U.S. stock market has good potential for upside this year. But looking ahead to 2013 and 2014, the economic picture becomes cloudy and so does market sentiment. What happens when interest rates go up to help deal with inflation? Market sentiment will decline and so will the stock market. In my view, the short-term economic policies of today are creating the longer-term economic stagnation of tomorrow.
This is the main problem affecting the investment decisions of institutional investors. There is no definable economic outlook upon which investors can make their bets. So, we’re likely to once again get choppy trading action in the stock market, with large-cap, dividend paying stocks as the outperformers. It’s a real problem. Why bother with the stock market at all if the economic outlook is so uncertain? It’s a very valid question. You might just be better off collecting gold coins. (See The Best Bet in Town—Resources—Getting Ready for the Big Squeeze.)
My best guess is that market sentiment will be strong enough over the next year or so to carry the stock market higher, so that the S&P 500 Index will complete its right shoulder formation. As I’ve written before, it’s an ominous-looking pattern that doesn’t particularly inspire confidence. Despite the larger scale, it’s very similar to the trading action experienced from the mid-60s to late 70s; which was a long period of choppy, zero returns.
So, my near-term outlook for the stock market is positive. Market sentiment should slowly improve commensurate with economic data. We’ve already seen an improvement in economic news during the fourth quarter. Longer-term, however, the structural problems facing both Europe and the U.S. economies are significant. Market sentiment is better now only because of irresponsible monetary and fiscal policies. Unless this changes, a real head-and-shoulders formation is likely and this implies that the right shoulder will at some point, break its neckline.