3 Reasons to Expect a 4th Quarter Rally

Modern debates no longer happen on stages with lecterns, or even over office water coolers.  They happen over Twitter.

I lobbed a tweet grenade at friend and InvestorPlace Editor Jeff Reeves for writing 11 Signs This Rally is Doomed,” calling him a buzz kill.  In reply, Jeff invited me to make my own arguments for why this bull may yet have a little room to run.

So, with no further ado, I’ll offer my own “3 Reasons To Expect a 4th Quarter Rally.”

Monetary Policy

As I wrote last week, ECB President Mario Draghi and Fed Chairman Ben Bernanke are in a monetary arms race of sorts to see who can inject more liquidity into the financial system.  And not too long after I wrote those words, Japan entered the fray with a massive injection of stimulus of its own.

The world’s third-largest central bank is expanding its quantitative easing problem by another 10 trillion yen to a full 80 trillion—or about $1.02 trillion in US dollars.  This adds to the Fed’s “QE Infinity” and Draghi’s “Big Bazooka” to what may collectively amount to the largest injection of monetary stimulus in history once the dollars, euros, and yen are counted.

I don’t usually pay attention to trader maxims and Wall Street clichés, but I think the advice to avoid “fighting the Fed” is sound here.  None of the stimulus measures are likely to create real growth in the economy, but they are very likely to inflate insipient bubbles in stock prices.

Big Investors Piling In

As was the case last year, the so-called “smart money” hasn’t looked particularly smart this year.  The average equity-focused hedge fund is up only 4.7% through the end of last month (see article), compared to 13.5% for the S&P 500.

This means there are legions of managers out there who are desperate to get their performance numbers up before the end of the year and willing to roll the dice to make that happen.  Hedge funds can generally make money on the upside or downside, of course.  But given the momentum behind the market right now, I don’t see many being brave enough to risk going short with so little time left in the year.

This week the Financial Times reported that the “masters of the universe” were embracing long-only strategies “amid volatile markets, constraints on the capacity of their main trading strategies, and an evermore conservative investor base.”

Bottom line, after a decade of waning institutional interest in equities, managers may be rediscovering the stock market for lack of anywhere else to go.

At the retail level, we also see investors warming to equities.  Weekly inflows into equity mutual funds just hit a four-year high of $17 billion.

Normally, I might consider this a contrarian signal that we’re nearing a top—and Jeff touched on this in his bullet points on market sentiment.  But much of this improvement in sentiment is due to the massive sigh of relief that the Eurozone didn’t disintegrate over the summer.  And I cannot stress enough how truly rotten investor sentiment had become after nearly five years of on again / off again crisis.   There was a lot of catching up to do.

Valuation

Most importantly to any value investor, stocks are not priced expensively enough to signify a major top.  I am the first to admit that markets can take short-term plunges for any reason or for no reason at all.  But real bear markets generally start with stocks priced aggressively, and I don’t see this as being the case today.

No, the S&P 500 is not “cheap,” per se, at 16 times earnings.  This is roughly in line with the long-term average price / earnings ratio for the index of 15.

But remember, we are not in “average” times.  Short-term interest rates are capped at virtually 0%, while the 10-year Treasury yields a pitiful 1.7%.  In a low-interest rate environment, stocks should have a premium valuation, and we simply do not see this today.

To be clear, no bull market goes straight up. There are always corrections or sideways consolidations along the way, and that is what we have seen for the past week.  Stocks have drifted slightly lower as traders take profits and digest their gains.

But until I see real signs of a breakdown,  I see no compelling reason to pull the plug on an aggressive allocation.

My advice?

If you’re feeling uneasy, tighten your stop losses or sell down some of your biggest winners of recent months.  But don’t go into bunker mode and miss what I expect to be an explosive end to 2012.

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This article first appeared on InvestorPlace.



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