Ramblings of a Portfolio Manager

The Neville Chamberlain Market?

The mid-term elections are over and they largely went the way of consensus with Republicans re-taking a majority in the House of Representatives and making inroads into, but not capturing, the Senate. The equity markets, ever the discounting mechanism, read the late polls and bid the market higher ahead of the actual results, leading us to believe that those results were indeed fully discounted on November 3rd. And like many observers, we expected some sell on the news action on that day, albeit shallower and quicker than the bevy of analysts in the financial media were predicting, primarily because that was what the bevy of analysts in the financial media were predicting. But then something happened that the skeptics, including ourselves, weren’t expecting: a quadruple of headlines that seemed to come from the equity owners’ Christmas wish list hit the tape. The sell on the news reaction, whether it was indeed a discounted discounting or actually responding to these headlines, turned out indeed to be shallow and quick. In fact, the “dip” lasted approximately a half a day.

The equity markets started strong the morning of November 3rd on post-election euphoria, even though some of the Market’s most wanted “villains” (e.g. Harry Reid and Barney Frank) survived the Democratic drubbing. The Market’s Santa list item #1 was soon delivered by President Obama, who appeared on TV to make what sounded to all like a conciliatory concession speech. In fact, the President sounded downright humble, if not contrite, in his pronouncement that he had learned from the “shellacking” the Democrats took on Tuesday. To many, that sounded so reminiscent of Clinton’s move to the Center after his first mid-terms that the Market rose even higher--but equities soon began to weaken as the Federal Reserve’s pronouncement on the size of QE2 drew near. While the markets earlier had initially expected close to $1Trillion in easing, a Wall Street Journal article late in October cut that expectation in half, to $500 million and there was unease that the announced number could be even lower. Santa list item #2, however, came around 2:15pm with the Fed announcing $600mm in expected easing with the potential for more to come if needed. The market’s reaction was swift and powerful, with the Dow gaining over a hundred points from its lows in about 2 seconds. Bonds sold off as rates rose in anticipation of a stronger economy down the road. Yet for all Wednesday’s volatility and drama, the markets closed the day essentially flat with many investors unsure what to make of the news they had just digested.

That was Wednesday and it seems that investors’ digestion period lasted exactly overnight. Thursday morning awoke to strong equity futures followed by a correspondingly strong opening to the US markets. Why? In our view, there were just too many people on the sidelines waiting for the post-election selloff to get back into the market (or cover shorts). When it didn’t occur on Wednesday, they panicked and jumped in feet first on Thursday. But Santa list item #3 was about to be released—that is, the unbelievable statement from President Obama that he was willing to consider extending the Bush tax cuts to all income classes—something about which he was adamantly negative pre-election. That pronouncement was the icing on the cake for the “move to the Center” crowd and the market rallied right into the close and by the end of the day the Dow and S&P 500 had closed up 2% while the Russell 2000, a proxy for risk taking, closed up 2.6%. The final Santa wish list item came on Friday with a jobs’ report that showed new jobs created over twice the consensus estimate. All combined, with the delivery of the Christmas list, the US equity markets closed the week with a 2.9% gain on the Dow, a 3.6% gain on the S&P 500 and a 4.7% return on the Russell 2000. Not a bad week considering that the consensus was for a big sell off.

So now that the big catalysts are behind us, with a few surprises thrown in, what can we expect from the equity markets for the rest of the year and into the next? In our opinion, it all boils down to the credibility of the President and the Federal Reserve. It was clear that Obama was doing a fair amount of public eating crow last week and much of it was for PR purposes--but if he stays true to his word on taxes and working with the new majority, we could see further gains ahead. The same holds true for Bernanke. If, indeed, the Fed is good for its $600+mm number, then rates can stay relatively low and the equity markets can continue to rally. But, as a former British Prime Minister discovered over 70 years ago, dealing with politicians can be a tricky affair. It’s not that they lie but they often “misspeak.” So we will keep our ears and eyes open to see if this market is expanding into fictitious Lebensraum or if, indeed, it is soaring on the wings of crows.