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Since the outset of September, the S&P 500 has climbed 12%. Remarkably, this significant market rise occurred during the two seasonally weak months of the typical calendar year. Prior to September 1, the market had given up most of its July summer rally as concerns grew about a growth slowdown in the U.S. economy and growing potential for deflation. In response, Chairman Bernanke of the Federal Reserve Bank indicated the likelihood of additional quantitative easing (QE2) in the months ahead to further support the economy and to reduce the risk of deflation. Bernanke’s statement triggered the markets rise together with growing speculation that the Republicans might take control of the House of Representatives and possibly the Senate as well in the November mid-term elections. Markets thrive on the creation of additional liquidity by the Fed, especially at times when real demand is not sufficiently robust to absorb this additional liquidity. Consequently, the stock market performed strongly during a normally weak seasonal period.

With stocks up strongly, November 2-3 just ahead with the mid-term election and likely news from the Fed about the initiation of QE2, investors are wondering how much of QE2 and the election is baked into the market? What, if anything, is needed to continue to spur the market higher? Are there potential negative surprises that may develop from QE2 and the elections?

There is no question that expectations about QE2 and the election have risen and the burden is on them to produce results exceeding these higher expectations since September 1. One disappointment possibility is that QE2 might be less than anticipated. This view was responsible for market weakness October 27. It is possible too, that the mid-term election may not go as well as hoped for the Republicans. Both of these potential developments could produce some set-back for the stock market.

Having acknowledged the possibility of some near term weakness in the market, we suspect that the market after pausing to digest its gains may be headed higher in the months ahead. A number of factors support this optimistic view. The seasonal period of November-February is typically associated with a rising trend in the stock market as investors look to a better year ahead. The economy, after weakening in the summer, may show a bit more strength as 2010 closes. Retailers have taken an increased inventory compared to last year. Sales may be very promotional as retailers try to capitalize on the best selling period in the calendar and consumers may be more responsive in their purchases than they were in last year’s holiday season. Confidence and visibility about the future may improve as a result of the election in which the Republicans take the House. The likelihood of further new programs from Washington entailing more debt may subside. Watch the response to the December 1 report by the Commission on Fiscal Responsibility for additional clues about confidence and visibility. This bipartisan effort may either produce more confidence about managing future deficits or prove to be another exercise in frustration. An easing of trade tensions of recent months could be another positive factor for the markets.

Two other possibilities are potentially bullish for the market. The prices of materials, energy, and food stuffs are rising. Soft commodity prices are up considerably in recent months. Oil prices have risen more recently. Some companies, notably Ingersoll Rand and Kimberly-Clark, have reported increased cost pressures on their profit margins in the third quarter from higher materials costs. The bottom line is that price inflation is alive and well and in the months ahead could lead to some rise in the consumer price index (CPI) as the consequence of rising commodities prices and the efforts of companies to obtain some margin relief through higher prices. The latter will not be easy in a relatively slow growing economy. Still, we believe that deflation could be perceived as a declining risk if the CPI were to rise at a bit faster rate in the future. While less worry about deflation might take some pressure off the Fed and produce a slower degree of QE2, we believe that more inflation might be positive for stocks, especially those with strong volume growth and pricing power. It might also boost the price of gold further.

The second possibility is the return of more investors, notably individuals, to the stock market. It is well known that individuals have been sellers of stocks and buyers of bonds for some time. Bond valuations, especially for Treasuries, are historically high unless the U.S. economy falls into an outright depression. The bull market in bonds started 28 years ago and has outperformed equities during most of that period. If and when inflation begins to manifest itself again, possibly in the form of a rising CPI in the months ahead, we believe bonds, especially Treasuries, will come under selling pressure. Equities may regain favor by those who have chosen bonds in lieu of stocks in recent years on the rationale that stocks tend to outperform bonds in a period of rising inflation.

Our sense is that equities may outperform bonds in the year ahead. Consequently, we believe stocks have more total return potential than most bonds. Portfolio allocations should begin to reflect this prospect.

A. Marshall Acuff, Jr., CFA
Managing Director
Director of Research
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC

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