There have been some emerging negative developments though, which have made us somewhat less bullish in the short-term and we have taken some profits on recent gains.  Certainly the fact that third quarter earnings are generally coming in above expectations once again is a positive.  But the amount of the ‘beat’ has been less than in the past few quarters and usually just coming on the earnings line rather than both the earnings and the revenue line.  More importantly though, has been the stock market reaction to the earnings.  After showing ‘blow out’ numbers to the upside, Caterpillar initially traded higher but then reversed direction to finish the day lower.  Same scenario on earnings reports from JP Morgan, FreePort McMoran, Intel, Honeywell, IBM and a host of other big-name US companies.  We always tend to get a bit concerned when stocks stop rising on good news, in much the same way as we view it as a potentially bullish sign when stocks stop going down on bad news. Another shorter-term concern is that stock market ‘sentiment indicators’ have once again moved to more bullish positions.  The Investors Intelligence survey of investment advisory sentiment shows the Bullish position having risen to 47% recently from about 28% in late August.  Bearish opinions, meanwhile, have dropped from over 40% down to 27% during the same period.  The result is that the ‘Net Bullish Position’ (i.e. Bullish less Bearish consensus) has gone from -13 to +20 in less than two months. Clearly the pessimism that dominated investor thinking at the August lows has dissipated.  Stocks are probably now more in the mode of ‘buy on rumour and sell on news’ for the next little while.  High expectations for the impact of quantitative easing are already reflected in the market as well as good third quarter earnings and some expected gains for the Republican Party in the upcoming US mid-term elections (which would impede somewhat President Obama’s spending plans and perhaps extend further the ‘Bush tax cuts’…..playing as well on the old adage that ‘gridlock is good for financial markets’).  Our expectation going forward is that the economic numbers should start to look better in the 4th quarter (judging from the commentary coming from most of the companies reporting earnings in the past two weeks).  As these better numbers come in, the magnitude and the benefits of a quantitative easing program might look less necessary.

Overall though, we remain bullish over the medium-term given that interest rates are expected to remain historically low, stock market valuations are relatively neutral and the global economy is in the early stages of a slow recovery from the 2008-09 recession. We have been increasing our weight in the Financial Service stocks recently after being underweight in the group since the market lows in early 2009.  Although the sector that leads one bull market rarely leads the following bull market, financial stocks have nonetheless become appealing on the basis of valuation and some improvement in earnings and capital adequacy.  It’s still going to be a long climb out of the hole that the sector got dug into with the excessive bad loans in the last expansion, but we think that we have seen the worst in at least the short-term for bank loans and home prices.  Banks, particularly in the US, should also benefit from some expected stabilization in the US dollar.  Pessimism about the ‘greenback’ has become far too rampant and we expect that there could be some recovery in the US dollar and some further weakness in the Euro as we head towards year end. This could prove to be a headwind for the commodity sector, which is another reason why we have increased our exposure to Financial stocks and reduced commodity exposure.

One of the bigger worries for investors has been what will happen when interest rates finally start to reverse direction and start heading higher again. With interest rates as low as they are the only direction that they can eventually start to move is up, unless we are truly in a period of deflationary pressures, which we do not believe.  The bigger question is ‘when’ not ‘if.’  But, contrary to popular opinion, past periods of interest rate increases have been surprisingly benign for stock price, as shown in the chart below.  The bars show the returns for the S&P500 Index 3, 6 and 9 months after the first in a series of interest rate increases (blue bars) and interest rate cuts (orange bars).  Surprisingly, the market returned higher amounts in each period following the rate hikes rather than the rate cuts, with the S&P500 being nearly 15% higher a year later.  Although the data set for this comparison may not carry enough information to be a reliable indicator, much of the strength could be related to the fact that interest rates tend to be raised during periods of economic strength and cut during periods of economic weakness.  Those factors may have had a bigger impact on the stock market return over the subsequent period as opposed to the interest rate move itself.  But the bottom line here is that investors need to not bail out of the stock market just because interest rates may be heading higher at some point. Many other factors have to be taken into consideration.

A more important consideration for stock prices is the direction of the global economy and its impact on corporate profits.  This has been important with the recent slew of earnings reports in which companies are pointing to continued strength in the Emerging Economies of the world.  The consensus from senior management on most webcasts we have listened to suggests that, while the US continues to struggle, Europe is recovering while Asia remains strong and Latin America is also seeing a resurgence in demand for capital equipment to support the growing mining, agricultural and industrial businesses in those regions. But what do the bigger picture numbers say about the state of industrial growth in the global economy?  As shown in the chart below of Global Industrial Production, after a sharp recovery in 2009, growth now seems to be reverting back to longer-term trend levels.  Over the past 40 years it can be seen that global industrial production (black line shows annual percentage growth in Global IP) has been strong coming out of most recessions (grey shaded areas on chart) but then moderates to trend growth over the rest of the recovery.  That situation seems to be occurring again with the current recovery, with the only difference being how sharp the contraction was during the recession (largest in over 70 years) and how strong the subsequent recovery has been, particularly since it was supported by global stimulus/spending programs as well as extreme loose monetary policy (i.e. record low levels of global interest rates).

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