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Here's what a leading bullish observer has to say about the stock market downturn: The highs seen last month aren't likely to be seen again this year.
That's the latest from Ed Yardeni, president and chief investment strategist at Yardeni Research. Sure, he's just one voice among many that follow the ups and downs on Wall Street – but this is a guy who has been arguing for some time that the bull market is alive and well, and not at risk of dying from old age or economic calamity any time soon.
He is still holding to that optimistic view: "Recessions kill bulls," he said in a note on Thursday. "This time, there hasn't been a boom, so the odds of a recession remain low."
Yet, he argues that several heavy factors – or what he calls the "worry list" – are weighing on market sentiment right now: Federal Reserve rate hikes, central bank credibility and a stronger U.S. dollar. These are unlikely to be resolved before the end of 2014, making a spectacular rebound unlikely.
"We aren't turning bearish, just less bullish about the upside prospects of the stock market over the rest of the year given the above concerns," he said. "We want to see how they play out over the next few months."
They appear to be playing out quite violently so far. The S&P 500 ended the day flat on Thursday after a dip in earlier trading threatened it with four straight down days. It has fallen a total of 3.6 per cent since mid-September.
The downturn is worse in Canada, where our exposure to sinking commodity prices has taken its toll: The S&P/TSX composite index has been down in nine of the past 10 trading sessions, for damage totalling more than 900 points, or 5.9 per cent.
If Mr. Yardeni is right about the issues weighing on the market, resolutions could take some time to arrive given that these look like emerging trends.
Many economists believe the Fed will start to raise its key interest rate mid-2015, and Mr. Yardeni thinks that isn't such a bad thing if it reflects confidence that the U.S. economy has at last achieved "escape velocity" – or the idea that the economy can grow without the need for stimulus.
But that doesn't mean the market won't freak out over the fear that the first rate hike will destabilize the economic recovery – or worse, cause the corporate bond market to collapse.
"Investors have been piling into the market as they've been reaching for yield. Corporations have responded by issuing bonds at a record pace," he said, adding that similar trends can be seen in Europe and emerging markets.
"Lots of those bonds have been purchased by retail and institutional investors, some of whom might try to sell them when the Fed starts actually raising interest rates. The problem is that the corporate bond market tends to be illiquid on a good day. This could be a nightmare scenario for bond funds if they are faced with lots of redemption orders with few buyers for their bond holdings."
Higher interest rates could also send the U.S. dollar to dangerously high levels, depressing U.S. exports. The dollar is already up, largely as central banks in Europe and Japan provide enormous stimulus to their respective economies, hammering the euro and the yen in the process.
The upbeat view here is the euro zone and Japan are pulling out all the stops to boost their economic performance. But as Mr. Yardeni cautions, "the weak euro and yen will simply allow the U.S. to share in [Europe and Japan's] miserable economic performances" if declining exports drag on economic growth.
Of course, the Fed could halt rate hikes the moment it sees that the first one caused havoc, but that simply creates another problem: It erodes central bank credibility at a time when investors are already losing confidence in the European Central Bank and the Bank of Japan following disappointing reports on inflation, manufacturing and corporate lending.
It's a lot to digest.
David Berman