What Drum is she Marching to?

The US and Canadian stock markets have gained back most of what they lost in the 2008 crash. Top to bottom, the S&P TSX 60 lost almost 50% in 9 months. Now, three years later in mid-February 2011, it has regained almost 75% of the loss. Those who believe in buying and holding the stock market are breathing a huge sigh of relief: it won’t be long before they break even.

Yet, somehow, we are told, the economy is still lacklustre. Unemployment is high and the housing market is weak. There’s no real spark in the economy. In fact, the America Federal Reserve Board tried to juice up the US economy with their Quantitative Easing 2 program in autumn 2010. How can the stock market stay strong when the economy stays weak?

In my investing book, Beyond The Bull, I explain the Counter-Cyclical Model. There is a relationship between the stock market and the economy, but it’s not what most people think. The stock market leads the economy. For example, the stock market bottomed in March 2009. Six months later the economy bottomed. The stock market led the economy by six months. That’s how the counter-cyclical model works. What does this mean for stock market investors?

This week the Canadian and US stock markets hit new recovery highs: they are still going up. If the counter-cyclical model holds up again for this cycle, the economy should be stronger in August 2011 than it is now. Knowing that doesn’t help us invest in the stock market, does it? We need something that leads the stock market to help us decide whether we should invest our 2011 RRSP contributions in the stock market at these levels.

I explain in Beyond the Bull what leads the stock market: it’s the bond market. Long term interest rates lead the stock market. For example, in December 2008, three months before the March 2009 stock market bottom, the US long term bond market staged a spectacular rally. For a brief time, it looked like the counter cyclical model was heralding a stock market low and eventually, an end to the recession. But, Quantitative Easing 1 threw a monkey wrench into the works. Whenever the Fed launches an easy money program, investors worry that inflation will heat up too much: long term bonds are not a good investment in times of high inflation. And, that’s exactly what happened this time: after a short spectacular up surge in December 2008, the US bond market dropped in a series of zigzags to the same level it was when the bear market of 2007-2009 began! The bond market is not correlated to the stock market in this cycle. It’s different this time.

Quantitative Easing is what’s different. The Americans are flooding their economy with dollars: their monetary printing press is going full bore. They are desperately trying to re-kindle a small amount of inflation. The normal lead-lag relationships in the economy are not working in this cycle. The president of the USA said it in his annual address to his people last month: QE2 has kept the stock market buoyant. Some of the money the American printing press is generating has found its way into the stock market. I wonder what will happened when QE2 dries up. Will the stock market’s up trend dry up too?

When the normal relationships in an economy change, investors have to be ready to change too. For now, the stock market is in a strong up trend and investors who are participating are doing just fine. It’s a bit like the children’s game of musical chairs: be ready to find a chair when the music stops.

To order your copy of Beyond the Bull and the Five Levels of Investor Consciousness CD, or to sign up for Ken’s free monthly webinar, visit www.gobeyondthebull.com (Bullmanship Code = SS32).

Contact Ken directly at ken@castlemoore.com.