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Rally a return to good times or sign of complacency?

Traders work on the floor of the New York Stock Exchange, July 31, 2012.


The good times are here again. Or at least that is what the market is saying.

The question, though, is whether stocks can add to recent gains or if the upbeat signals suggest a dangerous level of complacency.

Such concerns were nowhere in sight on Tuesday. In early trading, the S&P 500 broke the 1400-threshold for the first time in three months. It has risen nearly 10 per cent from its near-term low in early June and is now just 1 per cent away from reaching a new five-year high.

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In Europe, stocks are on a similar tear. The blue-chip Euro Stoxx 50 index has jumped nearly 18 per cent since early June.

But the upbeat mood is not only reflected in share prices. The CBOE volatility index – or VIX, a popular "fear gauge" that tends to rise as nerves fray and fall as nerves heal – has been meandering lower in recent months.

It recently settled below 16. That's extraordinarily low and near the very bottom end of its range over the past five years. It is certainly nowhere near levels seen during various flareups in recent years, when the index would occasionally spike above 40 during particularly hairy times for the market.

Even some European bonds – which reflect the region's debt crisis – are slumbering right now. The yield on Spain's 10-year government bond, which peaked in July at 7.5 per cent, has fallen close to a six-week low. Even more illuminating, the yield on Spain's two-year bond has retreated to about 3.6 per cent from 6.5 per cent in July, approaching a two-year low.

As bond yields fall, bond prices rise – and rising bond prices suggest investors are growing increasingly confident about Europe's ability to tame its debt crisis.

However, one of the strange aspects of this apparent shift toward good times is that it has not been accompanied by actual good news, and that includes Europe.

The euro zone economy appears to be mired in recession and Germany has been reluctant to give the European Central Bank the go-ahead to buy the government bonds of struggling countries like Spain.

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In the United States, the economic recovery has stumbled badly, despite an upbeat month of job gains in July. Yet, the Federal Reserve has been quiet about the need for an additional round of economic stimulus.

The second-quarter earnings season, which is now about 80 per cent done, is disappointing on a couple of fronts. Earnings for companies within the S&P 500 are growing at their weakest pace since 2009. As well, companies have been relatively unsuccessful at topping analysts' expectations – pointing to the weakest so-called "beat rate" also since 2009.

As for the third quarter, analysts have been busily cutting earnings estimates and corporate management has turned cautious, with twice as many companies reducing earnings expectations than raising them.

And from a technical perspective, the stock market looks downright troubled. As Mary Ann Bartels, head of U.S. Technical Analysis at Bank of America, points out, trading volume has been low and market breadth – the number of stocks participating in the rally – has been declining.

"The summer rally has been strong in performance, but not in the technicals," she said in a note. "This rally could be on stilts."

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About the Author
Investing Reporter

David Berman has been writing about business and investing since 1995. He has written for a number of magazines, including Canadian Business and MoneySense. He worked at the Financial Post as an investing writer and daily columnist before moving to the Globe and Mail in 2008. More


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