As we pointed out in a previous post, the action on the S&P 500 reminds us of a similar period in May 2008. Investors tried to rally the market above its 200 day moving average (see faint red circle) and failed…leading eventually to a 40% drop.

S&P 500 in 2008

S&P500 in 2008

Source: Bloomberg

This year, we are faced with a similar pattern. There is good news in the S&P 500 (75% of the companies have exceeded expectations in 3Q numbers) and the US economy is still growing (albeit at a sluggish 2-3% pace). When this pattern appeared in 2008, the US economy was already in recession (started from December 2007, declared on December 1st 2008).

This time around, while there is a significant risk that the US economy is already tipping into recession (ECRI declared one in September), the two big issues dominating the market continue to be the European Sovereign Debt Crisis and the Political Gridlock in the US.

The Euro Crisis impacts the largest economic area in the world on a combined basis. Unfortunately, the central design flaw of the Euro (monetary union without fiscal union) has been exposed. There is too much sovereign debt in Europe and too much of it is owned by European banks which in turn have too little capital to absorb any losses. Germany is the only player with the economic and political clout to resolve the problem and it has yet to decide on which expensive resolution to adopt.

The US continues to struggle with political gridlock which in normal economic circumstances might not be such a problem. However, with such tepid consumer demand growth and a corporate sector keener to horde cash than invest in new projects and employees, the issue of the federal budget is causing deep anxiety amongst investors. For the middle of the road voter, who will once again swing the election next year, the choices are stark and surprisingly well understood. The Republican plan emphasizes spending cuts and will translate into an immediate reduction in GDP. The Democratic preference for stimulus spending financed with higher taxes will lead to a more gradual reduction in GDP but runs the risk of blowing out the deficit and attracting the negative attention of the bond market.

Neither outcome is particularly good for corporate profits and stock market performance. This is why we are seeing the October rally start to fade.

S&P 500…last six months.

S&P500 Today

Source: Bloomberg

What should investors do?

The System continues to favor short ETFs, short term US government paper and Gold. In other words, there is no underlying momentum in risk assets that should give one confidence at this time. The fate of the macro-economic foundations of half the globe’s GDP is in the hands of politicians who are faced with no easy choices and one of the leading forecasters of business cycles has called for a recession in the US.

We have often observed that the Bull Market slogans of the 80’s and 90’s (Buy and Hold…Buy the Dips) have served investors poorly since the dawn of the new millennium. At this juncture, we would remind investors of that observation continue to maintain a cautious investment stance.

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