March 28, 2024

Strategies: How Long Can the Stock Market Forget About the Pain?

Despite a ho-hum week, the Standard Poor’s 500-stock index has already gained more than 4.6 percent in the young year, and emerging markets have done even better. The Hang Seng index in Hong Kong has risen more than 11 percent, even counting time off for the Lunar New Year holiday.

In the United States, some strategists’ year-end targets are already at hand. Jim McDonald, the chief investment strategist for Northern Trust, for example, projected that the S. P. would finish the year at 1,330. It briefly surpassed that mark last week.

“The market may have front-ended its returns for the entire year,” Mr. McDonald said. For the moment, he is not upgrading his forecast.

Others are similarly cautious. Jeff Applegate, the chief investment officer at Morgan Stanley Smith Barney, expects that both “Europe and the United States will slip into recession this year.” Therefore, he said, “we think there’s risk of more downside” in the market, so the firm has recommended that clients cut their exposure to stocks.

In short, despite the buoyant returns so far this year, it may not be time for investors to whistle, “Don’t worry, be happy.”

While there has been some good news, the economy isn’t really on firm ground. No less an authority than Ben S. Bernanke, the chairman of the Federal Reserve, shares that view. “I don’t think we’re ready to declare that we’ve entered a new, stronger phase at this point,” he said on Wednesday.

Fed policy makers last week underscored their fundamental pessimism about the outlook through late 2014. They said they expect to keep interest rates near zero until then — one year longer than earlier indicated. And for the first time, the central bank issued detailed long-term predictions. The purpose of this exercise, Mr. Bernanke said, is to convince investors that interest rates will remain very low, thereby stimulating growth.

But the new information adds color to the central bank’s grim assumptions, with Fed officials anticipating economic growth that will be too weak to make much of a dent in unemployment. The Fed evidently believes that a true recovery from the Great Recession and the global financial crisis is still years away.

The European sovereign debt crisis may have receded from its dominant position in the headlines, but it remains a global flash point, capable of exploding at a moment’s notice. The European Central Bank, under Mario Draghi, its president since November, is providing ample liquidity to the region — helping to keep financial markets lubricated and the yields of crucial Italian and Spanish bonds at manageable levels. The bank has been buying time.

Despite numerous summit meetings, conclaves and agreements, the underlying problems in Europe are unresolved. In an essay in the New York Review of Books, George Soros, the financier, compared Europe to a car in a dangerous skid. First, he says, to avoid a catastrophe, European leaders need to steer in the direction of the skid — toward the draconian fiscal policies that are plunging the Continent into recession. Once a modicum of control has been regained, though, Europe needs to shift to a more sensible course, he says. He recommends economic stimulus, as do many economists. Mr. Soros is calling for bonds guaranteed by the European Union, but many other options have also been proposed.

At best, avoiding a greater calamity will entail an extraordinarily difficult series of maneuvers. Consider that there is no single driver at the wheel but rather dozens of politicians and administrators from 27 governments in the European Union, and numerous multilateral institutions, financial entities and closely linked non-European countries. Most have strong views about what needs to be done.

No wonder, even in this period of relative calm, that fear remains so close to the surface.

Researchers at HSBC in London and at Oxford University have been studying the phenomenon. They say world financial markets have been dominated by a “risk-on, risk-off paradigm” since the onset of the global financial crisis. I wrote about their research in April. Global financial assets were moving in lockstep. Since then, says Stacy Williams, an HSBC strategist in London, correlations have tightened much further. They reached “absurdly high levels” shortly before Christmas.

The new year has brought a relative lull, to be sure, and correlations have dropped somewhat. Even so, he said, the United States equity market is very highly correlated, both with other markets and internally. Late last year, he said, the correlation of individual stocks within the S. P. 500 “exploded to insane, never-seen-before levels, so that all stocks look and behave almost the same.” For old-fashioned stock picking, this is a nightmare, at least over the short term, he said, since the nuances of any particular company are being overwhelmed by broader market forces.

The situation also makes it very hard to execute hedge fund strategies aimed at exploiting the differences between equity sectors — bets that utilities, for example, will outperform industrials. Such strategies require a higher degree of sophistication than many such traders can manage, he said.

Over the last few weeks, “risk on” trades — embracing stocks, which Mr. Williams called the “quintessential risk-on asset” — have generally been in favor. At some point, if the “risk-on, risk-off paradigm” prevails, investors will move en masse to dump stocks, and bid up safe-haven assets, that for now include Treasury bonds and United States dollars.

What is an ordinary investor, one with no claims to financial sophistication, to do under these circumstances? The same thing he or she should do under most circumstances: maintain a well-balanced, diversified portfolio while trying not to worry too much about day-to-day market noise.

Of course, investors trying to save enough for retirement or for a house or for a child’s education need to assess the amount of risk they can bear and the amount of time that they can wait for a return on their assets. Right now, Mr. Applegate advises investors to “underweight” equities and to add some riskless ballast like cash and short-term Treasuries.

Long-term investing in the stock market requires some confidence “in the future economic health” of capitalism, Mr. Williams said, which may seem a tall order on some days. Still, he has been making such a bet in his own retirement account, “like just about everybody else,” and hopes that the unusual market movements of the last several years will ultimately abate.

“If you are trying to be sophisticated, be sure that you are being really sophisticated,” he says. Otherwise, consider taking some risk off the table.

Article source: http://feeds.nytimes.com/click.phdo?i=eca7f08042b99ee6901e0e64710297d0

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