Two Years of Fears Have Disappeared!

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Kudos to central banks.

The eurozone debt crisis produced two years of fears that it would result in financial collapse and a severe recession in Europe that would spread to the rest of the world.

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But in November the central banks of Canada, England, Japan, Europe, the U.S., and Switzerland, took coordinated actions to provide liquidity support to the global financial system.

In December, the European Central Bank finally succumbed to pressure and launched a program providing substantial additional liquidity to European banks by making unlimited, low interest-rate, three-year loans available to banks.

As a result, while questions remain about the bailout of Greece, and a potential recession in Europe, fears of a total collapse of the 17-nation eurozone financial system have gone away.

In the U.S., massive government bailouts and record deficit spending prevented the bursting of the housing bubble and resulting 2008 financial crisis from dropping the economy into Great Depression II. The severe recession ended in June, 2009, and an anemic recovery has been underway since.

When the recovery stumbled in the summer of 2010, the central bank of the U.S., the Federal Reserve, rode to the rescue with its QE2 stimulus program, putting the recovery back on track.

When it stumbled again last summer, the Fed rode in again with another bond-buying rescue effort, ‘Operation Twist’, and the economy found its footing again, this time with the increasing strength of the recovery over the last four or five months surprising economists.

So again, kudos to central banks.

Investors should be particularly thankful. Unemployment remains high, and home-owners continue to struggle with the double-digit declines in home prices. But the stock market, as measured by the S&P 500, is up exactly 100% since its March, 2009 bottom, and up 24% just since its intermediate-term low in October.

It has primarily been institutional investors, corporate insiders, and other professionals that have benefited from the three-year bull market, while individual investors have remained bearish and pessimistic, and still pulling money out of stock mutual funds, in favor of cash and bonds.

However, even usually astute hedge funds experienced losses and their worst performances in years in 2010 and 2011, disbelieving the economic recovery and the market’s strength and betting against them. Many famous names gave up altogether and closed their funds.

Much is now being said about the fact that individual investors are finally becoming bullish and optimistic, perhaps too much so given that usually savvy corporate insiders are now selling heavily and the market is short-term overbought.

And as I have been writing for the last two weeks, the market’s short-term overbought condition, the high level of investor bullishness and insider selling, as well as a few other short-term conditions, has the market at risk of a correction, but probably only a short-term correction.

Where are the catalysts for something worse?

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The U.S. economic reports this week continued to surprise on the upside, and even if the recovery were to stumble again the reversal would show up slowly in the monthly reports, first a softening of the numbers, before they would turn negative.

And the Fed still has the market’s back, Fed Chairman Bernanke saying as recently as last week that the Fed stands ready to provide more stimulus if the economy requires it, as long as doing so does not risk creating inflation. And this week’s PPI and CPI reports showed inflation remains benign.

Thus the risk of a short-term market correction, perhaps tradable, due to the overbought condition, but then a recovery to higher highs by the end of the market’s traditional favorable season in April or May

However, after a five-month intermediate-term rally to an overbought condition, it is a time to be alert for changes.

A substantial correction is likely again this year in the market’s unfavorable season.

The catalyst for such a market decline is liable to come out of Europe again, perhaps from an actual debt default by Greece, or a worsening spread of the crisis to Italy or Spain. But more likely, by then it’s liable to be clear that Europe has slid into another recession, perhaps accompanied by recessions in China and Japan if their problems persist.

So, two years of fears have pretty much disappeared for now and optimism is high.

However, central banks will probably have another set of problems on their hands by April or May, summer at the latest, and the important question for investors is when might markets begin to anticipate those problems and factor them into stock prices.

Stay tuned!

Sy Harding is president of Asset Management Research Corp., and editor of the free market blog Street Smart Post.

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avatarSy Harding - Street Smart posted Friday, February 17th, 2012.

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