Why I expect to get a Santa Claus rally this Christmas

Founder and Publisher of the Switzer Report
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It would be great to look at the Dow Jones Industrial Index’s 125-point gain over the weekend and think the worst is behind us – and it could be – but we have to expect more volatile days ahead.

The two big issues to watch are the same ones that caused last week’s drama: European debt management and the likelihood of a US double-dip recession.

If you’re a nervous Nellie, don’t think you are a shag on a rock. Local swap traders are factoring in a 137-point fall in official interest rates over the next 12 months and this negativity relates back to the fear of the unknown.

That said, money market pricing can be rather over-reactive and not always a reliable guide. Economists are becoming more negative, with Westpac, St George and Deutsche Bank now in the rates-will-fall camp. However, most economists still think rates are on hold for a sustained period. This reflects their more optimistic we-will-muddle-through view, which I have certain sympathy with for the big picture.

But, I still think the benchmark interest rate needs to be cut by 0.25-0.5 basis points to bolster local consumer and business confidence – but that’s in the hands of Glenn Stevens and the Reserve Bank board.

Since the start of August, some $7 trillion has been lost on global stock markets. This hurts both demand and confidence and will ultimately have a negative impact on economic growth. My greatest concern centres on the US economic outlook, even though I think it will improve in the final quarter of 2011, taking stocks with it.

I’ve been betting on a ‘Santa Claus rally’ for shares around Christmas that will coincide with the historical story that stock markets do well in the final two years of a presidency.

Worrying factors that could cause this inclination to fail are that the current president has a huge global and local economic challenge to beat on top of a genuine lack of power over policy; firstly, because of the make-up of the Congress, and secondly, because of a lack of money to easily splash around to pump up the economy – and his popularity.

Right now the VIX, or fear index, is up at 36, which is high. We also start this week on Wall Street with the Dow off 1.53% over the week and the S&P 500 down 1.72%. We need good news – and fast – to beat the bears to the punch this week.

So what does IHS Global’s chief US economist, Nigel Gault, see in his economic crystal ball?

Gault says US gross domestic product (GDP) growth was tracking at an annualised pace of only 1.3% in the second quarter, with little evidence of better times ahead. And while employment has improved, he doesn’t see signs of acceleration in output growth outside the motor vehicles sector.

What this points to is that amid increasing inventory stockpiles caused by the recession and the effects of government spending wearing off, the Yanks are once again relying on the consumer and housing to generate growth – yet these two forces are weak; consumers have debts and there’s an oversupply of housing.

To make matters worse:

  • Confidence in US policymaking has hit new lows, as the artificial debt-ceiling crisis took the country to the brink of default.
  • The S&P downgrade of US debt hurt sentiment.
  • The eurozone sovereign debt crisis is being mismanaged.

Gault says: “European policymakers have been consistently one or two steps behind the markets in their reaction”. That’s a nice way of saying they are dopes!

All this has caused Gault to revise down his US economic growth outlook for 2012 to 1.9% from 2.6%. He doesn’t think there’ll be a recession, but says there’s about a 40% chance one could hit.

Now the only two things I can offer to allay investor fears after reading this are:

First, the recent sell-off was because of this kind of analysis, however, the worst-case view of a recession has already been priced.

Second, this is the analysis of an economist and these guys (though I am one myself) don’t have a reputation for accuracy.

For me, the main game for our share market is European debt management and the US economy, and I remain hopeful of a final quarter rally for shares.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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