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Stimulating Upside for (Some) Stocks


The tug-of-war between weak economic data and stimulus from central banks is creating a polarized and unpredictable market. Here's how to navigate the next several months safely.

The latest employment report from the Bureau of Labor Statistics (or BLS) showed that there were only 103,000 private sector jobs created in the month of August, far below consensus market expectations for 142,000 jobs.

The jump in the four-week average of initial jobless claims to 375,000 suggests that jobs creation is likely to remain anemic into September.

Meanwhile, recent data indicates that Europe remains mired in a significant recession and the Chinese economy has slowed sharply over the past year. The latest reading on the HSBC Flash Purchasing Manager's Index (or PMI) for manufacturing in China was 47.6 in August; levels under 50 indicate a slowing manufacturing sector.

Despite this litany of troubling economic evidence, global stocks have soared. The S&P 500 hit its highest levels since early 2008 while Germany's DAX and the UK FTSE 100 are both within a few percent of touching four-year highs.

Strength in global equity markets in the face of weak economic data has been driven by yet another round of stimulus from central banks. On September 6, the European Central Bank (or ECB) and its president Mario Draghi ended weeks of speculation, announcing the Outright Monetary Transactions (or OMT), a program to purchase bonds issued by fiscally troubled EU governments in an effort to drive down yields.

Under the terms laid out by Draghi, countries that have applied for support from Europe's bailout funds-the European Stabilization Mechanism (or ESM) and its predecessor the European Financial Stabilization Facility (or EFSF)-and agreed to fiscal austerity conditions are eligible to receive support from the ECB.

Unlike the ESM, the ECB will not buy bonds directly from governments on the primary market, but will purchase securities from other traders on what's known as the secondary market.

By buying bonds, Draghi hopes to push down borrowing costs for floundering countries such as Spain and Italy. The ECB stated that it would buy bonds in unlimited quantities. By not setting a maximum bond purchase target, the central bank has made it tough for traders to bet against bonds issued by troubled European nations or the euro common currency itself.

The ECB announced OMT over significant German objections, but it made a few minor nods to German concerns. First, to qualify for OMT countries must already be working on a fiscal adjustment program and the ECB can terminate the program at any time if it feels countries aren't living up to their fiscal objectives. Second, the ECB will concentrate its purchases on bonds with one to three years left to maturity rather than longer-dated securities. Consequently, governments can't look at the ECB's bond purchases as a long-term financing vehicle.

The ECB will sterilize its bond buying, meaning that the bond purchases won't increase the total money supply in the euro zone. Historically, the ECB has sterilized its activities by offering banks short-term interest-bearing deposits. As banks park their excess cash at the ECB, it's temporarily removed from the money supply.

Just the suggestion of unlimited bond purchases from the ECB was enough to send the yields on Italian and Spanish bonds back to their 2012 lows. That's despite the fact that neither Spain nor Italy has applied for help from Europe's bailout funds, which means these nations would not be eligible for support from OMT.

For several months, I've expected the US Federal Reserve to start up a third round of quantitative easing (QE3) before year-end. However, on September 13, the central bank did even more, announcing an open-ended program to purchase mortgage-backed securities at a rate of around $40 billion per month until the labor market shows substantial improvement. The Fed also hinted that it might be willing to expand its purchases to buy Treasuries or other assets as well as mortgage-backed bonds as needed.

This open-ended statement is the first time the Fed has tied its quantitative easing directly to an economic objective-faster jobs creation-rather than setting a specific time and cap on the size of QE. The Fed's balance sheet has already exploded in size from around $600 billion in 2001 to more than $2.8 trillion today, primarily because of its purchase of bonds through two rounds of quantitative easing in the wake of the financial crisis (see the below chart "The Story on Stimulus").

This latest announcement is likely to result in a $500 billion or more additional increase in the Fed's holdings of bonds. This is nothing short of uncharted territory for central banks because never before have global monetary authorities been so accommodative.

I've recommended investors retain a defensive stance due to the rising risk that a combination of weak economic data and the potential for a disappointment out of either the Fed or ECB would result in a significant broader market correction.

I was right about continued weakness for the US and European economies. However, global central banks have delivered the expected monetary stimulus and then some, feeding investors the stimulus they crave and lowering the risk of a significant correction before year end.

Regardless, I continue to recommend that investors avoid getting caught up in the market's wild swings and euphoria. Defensive groups such as consumer staples and health care traditionally lag the broader market during major rallies, but these groups are up 12.6% and 16.4% respectively this year, compared to about 17.8% for the S&P 500. Yet, both health care and consumer staples are far less volatile than the S&P 500 and they've avoided much of the carnage of the April-May market pullback.

Meanwhile, less volatile large-capitalization stocks continue to outperform the small fry, with the S&P 100 up more than 19.5% in 2012 compared to just 16.9% for the S&P 600 Small Cap Index.

Groups that are more economically cyclical have lagged this year, due to continued concerns about global economic growth. Notably, the S&P 500 Industrials Index, a group normally expected to lead a strong market, is up less than 13% this year.

Sticking to defensive groups and large capitalization stocks and favoring companies that offer a significant dividend yield continues to be the preferred course. You won't be forced to give up much (if any) upside, and your portfolio won't be exposed to the extreme bouts of volatility that have characterized the market over the past two years.

It remains unclear when or if this latest round of central bank easing will provide real economic help, but it will take a few months at a minimum for better data to emerge from the US and Europe. Until we see empirical evidence of a turnaround, it's advisable to avoid cyclical groups such as the industrials.

Finally, the deluge of stimulus measures announced over the past few weeks has pushed up inflation expectations. That's great news for prices of oil, gold and agricultural commodities.

This article was written by Elliott Gue of Investing Daily.

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