Friday, March 19, 2010

U.S. Stock Market in the First Quarter of 2010

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Today is quadruple witching, a once every quarter event that takes place on the third Friday of March, June, September and December. On these dates, contracts for stock index options, stock index futures, stock options and single stock futures all expire. While media reports usually focus on volatility during the expiration date, far more important is the trading that takes place in the proceeding weeks. Prices will tend to move to minimize the value of outstanding options due to hedging, if not for other reasons. A negative outlook in February seems to have led to a nice rally in U.S. stocks during March.

Stocks started the year off with a mildly bullish tone and hit a peak in mid-January. The Nasdaq and Dow Transports hit a high on January 11th, the Dow Jones Industrial Average on January 14th and the S&P 500 and Russell 2000 on January 19th. All the indices sold off into February on news of reductions in liquidity from the U.S. Fed and restrictions on bank lending in China. The moves withdrew very little money from the global financial system however. The world's markets are still awash in liquidity. The U.S. dollar was also rallying during this time and since the stock market rally began in March 2009, the dollar and stocks have tended to move in opposite directions.

Stocks then started rallying off their February lows in a stronger dollar environment. This pattern first became evident recently in December 2009 when the trade-weighted dollar rallied strongly and so did stocks during the month. It would perhaps be more accurate to say the euro experienced significant weakness during these periods because of the crisis in Greece (the euro represents over half of the trade-weighted dollar). December represented a shift in trading patterns for the U.S. dollar and stocks for the current the rally.  Investors should note if the strong-dollar strong-stock pattern continues. While it was common in the 1990s, the opposite has been the case for much of the 2000s.

All the major indices hit new current year price highs recently. The Russell 2000 was the first on March 2nd, followed by the Nasdaq on March 5th, and the S&P 500 on March 12th. The Dow Transports hit a new high on March 10th before the Industrials hit a new high on March 17th. New highs are of course generally bullish.  Small caps have been doing best in the rally. This indicates higher risk tolerance on the part of investors and is also something that happens in inflationary environments. Small caps outperformed during the second half of the high-inflation 1970s following the deep recession of 1973 to 1975.

U.S. stocks can continue to do well as long as liquidity is being pumped into the financial system. Liquidity is the driver of prices and not the economy as the mainstream media constantly reports. Liquidity shows up first in the markets and later on in the economy if everything works according to plan. The Japanese in the 1990s and 2000s found that this Keynesian style plan didn't always work however. If things get too bad because too many excesses have built up in the financial system, the liquidity fix is no longer effective. U.S. investors also need to realize that money has flowed out of Europe and into the U.S. and a resolution of the Greek crisis will cause funds to flow out of the U.S. and back into Europe. Moreover, actions the Chinese take can also impact U.S. stock prices. China raising interest rates would be a negative for U.S. markets. Revaluing its currency upward would also shake things up.

Disclosure: None

NEXT: Who Really Benefits From the U.S. Healthcare Bill

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

1 comment:

Tom said...

Thank you for your interesting article. Any chance you could explain in greater detail the reason why increased liquidity first shows up in the market and then later in the economy? What is the mechanism for this dynamic?