Some say there’s a great conundrum occurring in the market currently – how can we be on the verge of recession in the USA, in the midst of this continual depression in parts of Europe and still have the S&P 500 near the highs of the year? John Hussman says he has the answer in this latest letter:
“The key question – in view of extreme credit market strains in Europe, and accelerating economic deterioration in the U.S. – is why the S&P 500 continues to trade within a few percent of its April bull market high. The answer is simple: investors are scared to death of missing the widely anticipated market advance that they expect to follow a widely anticipated third round of quantitative easing.”
I think it’s a bit more complex that just the Fed and QE3. First, I don’t think the market is pricing in a recession, because, as Wall Street’s GDP consensus for the next few quarters clearly shows, a recession isn’t expected. But more importantly, equity prices in the USA are primarily a function of corporate profits and even though there are signs of deterioration in profits neither the Euro crisis nor signs of deterioration in the US economy has actually led to a signification decline in profits.
So yes, I would agree with Dr. Hussman that the Fed plays an important psychological role here, but ultimately, it’s corporate profits that primarily drive the equity markets and while QE may have all sorts of mystical psychological impacts it is having very little impact on profits overall. And until we begin to see significant deterioration in the profit picture we’re unlikely to see significant deterioration in the equity markets.*
* When I say “significant” I mean 20%+ declines consistent with bear markets.