For much of calendar year 2010, investors have taken a binary view of the stock market. In short, it’s been a “red light, green light” approach to investing in risk assets such as stocks. When traders are feeling good about the future macroeconomic outlook, the battle cry becomes “risk on” and stocks are bought in anticipation of blue skies ahead. Yet, when uncertainty has arisen from any number of areas, the mentality has quickly changed to “risk off.”
More recently though, the market seems to have adopted the “Tepper Trade” (originated by hedge fund manager David Tepper) mentality where stocks are seen in a positive light regardless of what is expected to happen to the economy. This “win/win” scenario comes from the view that stocks will obviously gain ground if the economy improves going forward. Frankly, this is hardly groundbreaking analysis. But what is different at the moment is the idea that stocks can also be bid up should the economy take a turn for the worse.
This heads-stocks-win, tails-stocks-win view is based on the idea that Bernanke & Co. absolutely, positively will NOT let the economy head south again on their watch. Thus, if the current soft patch worsens, traders embracing the Tepper Trade are betting that the Fed will ride to the rescue, producing a positive environment for the stock market in the process.
On the surface, this seems to make an awful lot of sense. While Fed officials are hardly all on the same page right now, the FOMC has made it abundantly clear lately that they stand ready to do whatever it takes (including the launch of QE II, to the tune of another $500 billion - $1 trillion) to keep the economy from falling back into recession.
However, there is a third option to consider when looking at the economy – one that doesn’t really offer up a warm-and-fuzzy outlook for the stock market. While everyone may be correct in their assessment of what may happen should the economy move either up or down from here, what about the idea that the economy simply “muddles along” going forward? After all, this seems to be the most likely outcome given the current economic data.
The key point here is that Fed officials have also made it clear that the launch of QE II (another round of quantitative easing) is NOT a sure thing and the implementation of further measures will be dependent on the data. In other words, if things get worse, the Fed has said they WILL act. But if things improve, Bernanke has suggested that the Fed may not need to do much of anything.
So where does this leave stock market investors if the third option – i.e. muddling through – becomes the new normal? Our guess is the Fed can’t/won’t take action should a slow-growth environment ensue, which could become a problem for traders.
But, before you decide to grab the helmet and dive back under the desk, we should also keep in mind that corporate America has always been able to adapt to changing environments. For example, even during this less-than stellar economic rebound, companies have found ways to continue to produce profits. Sure, they have cut costs in order to do so, but the bottom line is that the profits have been generated. Thus, there is little reason to believe that corporate America won’t continue to adapt to a new environment.
Another thought for those that see the glass as half full is the idea of global diversification. Let’s face it; most of the fortune 500 companies are now global in scope. Therefore, those companies that sell their wares globally will benefit from the exploding growth in places like China, India and other emerging markets. Yes, growth in the good ol’ USofA might be slow, but with China’s GDP still growing at a double-digit rate, well, there might still be some opportunities around the world.
As for trading tactics given the “third option,” where the economy muddles along with below normal GDP growth, my assumption is the stock market could struggle initially as neither of the current assumptions (heads: stocks win, tails: stocks win too) take hold. However, I am of the mind that after a stiff correction, traders just might start to appreciate what could easily turn out to be surprisingly good earnings growth.
My final thought this morning is that if this “third option” scenario plays out in the market (first a correction, then an earnings-based rebound), we would likely see the return of a “stock picker’s” market. Currently, the game is all about the macroeconomic trends and most everyone still in the game is trading ETF’s based on the news. However, if the economy stabilizes and a trend of slower growth develops, I’ll bet that stock picking might once again be the name of the game.
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