Bad News? No Problem

The resiliency of the stock market has been amazing. The yield curve is inverted, bonds are rallying even as inflation and wages rise at 4% per year. House prices show the first price fall in over 10 years and housing stocks outperform. Oil, even after a 25% correction, is around $60/barrel. Republicans lag badly in the mid term election polls. North Korea tests a nuclear weapon (maybe). Iran defies the world in continuing nuclear research (well most of the world anyway). And the Dow makes a new all time high. What gives?

It always pays to remember that markets are discounting mechanisms. What markets do today reflects investors view of the future, not the present. Yes, current inflation is too high, but commodity markets are signaling that the peak is past, so stock market investors believe inflation is under control. Yes, the housing market is weak, but with interest rates falling, refinancing activity picking up and homebuilders in good financial shape, investors believe the downturn will be over fairly quickly. And if history is any guide, they are probably right. Yes, oil is high by historical standards, but its falling, OPEC is talking about production cuts and there have been some major new finds recently. OPEC doesn't have a good track record when it comes to controlling prices either so even the threat of production cuts is having little impact. Investors are looking past the current price and factoring in the increased cash flow of consumers as gas prices fall.

North Korea and Iran certainly seem scary, but the paucity of yield in the North Korea test signals either a lack of fissionable material or maybe even an outright hoax. Iran, while acting obstinate, is probably further away from a bomb than the doomsayers think (but probably closer than we would like). They may be a problem down the road, but that assumes that the current regime survives. With a restive, young population that is probably a longer shot than the mullahs think. Did anyone notice the confrontation between Iranian citizens protecting a dissident ayatollah (who thinks that clerics should stay out of government) and government goons? Read about it here.

As for the midterm elections, apparently investors have adopted our view that it makes little difference who controls Congress. Will Republicans lose control of the House and Senate? Futures markets are currently predicting a 36% chance they will retain control of the House and a 63% chance they will retain the Senate. Frankly, with the advantages of incumbency I think the odds of a Democratic takeover of the House are somewhat lower than that, but then I'm not betting on the outcome. Investors seem to be saying that it doesn't matter. In fact, I believe a lot of investors are thinking that divided government would be better than one party control. And they are probably right.

Another factor to consider in the recent runup is sentiment. We typically like to bet against the crowd and this rally has plenty of sceptics. The latest AAII (American Association of Individual Investors) poll still shows more bears than bulls (46.7% to 37.8%) so the little investor is still scared of the market. He's probably thinking about the spring when a run at new highs was turned back by a nasty correction. That's okay; when the bulls start running we'll be looking to cut back, but for now the wall of worry is still fairly tall.

Predicting the future is always a tricky business, but especially when it seems there are so many potential problems. Are investors too optimistic about the outcome of all these things? Maybe, but for now, there aren't enough optimists to make us worry. When the small investor starts to jump on the bandwagon, we'll start to worry. For now the small investor is still chasing last year's returns - inflows to international funds are swamping inflows to US funds even as the US outperforms. It seems dangerous to us to invest (or drive) by looking in the rear view mirror.