3 Reasons The Stock Market Rally Could Falter

stock rallyRuss Koesterich: The US stock market rally that kicked off the New Year continued last week, and after only two weeksUS stocks are up around 3% for the year. European stocks have posted similar gains and equities in Japan have advanced even further. What’s behind this rally – and more importantly, can it continue?

In my view, the rally can be attributed to three factors. The first is obviously relief over the fiscal cliff deal. Also, some investors sold winning investments in December in an attempt to generate capital gains in 2012 before capital gains taxes were scheduled to increase in 2013. Because capital gains rates did not change for most Americans, however, many investors are now buying back the stocks they had sold.

Second, stocks are benefiting from a normal period of seasonal strength. While the so-called “January effect” may not be as significant a trend as some would believe, there is a modest historical tendency for stocks to advance in the first month of the year.

Finally, economic data has generally been better than expected, not just in the United States, but also globally. Manufacturing data from China is confirming that an economic hard landing has been avoided and there are also some similarly positive signs from the US financial services sector. The global economy is starting 2013 with some momentum.

But it is important to remember that at least the first two of these factors are likely to be temporary. True, I expect equity markets to continue to advance and to outperform bonds for the year as a whole, with the best performance likely coming in emerging markets. But I believe the current pace of gains will slow—if not immediately, then probably by February. Here are three reasons why I remain cautious in the near term:

  1. Expect a good deal of headline risk coming in the next couple of months. Investors should expect continued dysfunction from Washington as lawmakers wrestle with the debt ceiling, scheduled spending cuts and the need for continuing budget resolutions. Not only are the odds of some sort of “grand bargain” diminishing, but the current bickering raises the possibility of another last-minute showdown and a potential debt downgrade.
  2. There is political risk coming out of Europe, with Italian elections approaching in February. Should the election fail to produce a clear result, or should the voters choose a less market-friendly government than the one currently headed by Prime Minister Mario Monti, markets would likely react negatively.
  3. There are lingering concerns about the US economy. Once we get a look at January month-end data, we will see the first clues about how higher taxes are impacting the economy. Notwithstanding some of the stronger data cited earlier, I expect the first quarter to show relatively soft economic data. In particular, I’m concerned about consumption levels weakening in January as people come to grips with smaller paychecks.

Moreover, while these risks are clearly evident, investors seem to be overly complacent.  The VIX Index (a widely followed measure of stock market volatility that is also known as the “fear index”), fell last week to its lowest level since June 2007, suggesting that there is not much bad news priced into market right now. That means any negative shock would have the potential to drive markets lower.

The bottom line is that while stocks are reasonably valued (particularly outside the United States), expect tougher going as we head into February.

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

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