Why the Rally? No Calamity

The stock market engines aren't terribly concerned with either the economy or corporate earnings. So long as the bottom isn't falling out, that's enough.

Maybe the economy will grow 1.5% this year and 2.5% next year, or maybe it won't. The critical factors are the central banks (i.e., the Federal Reserve and the European Central Bank) and the calendar.

Most of all, it's the two central banks. So long as they profess a willingness to support their economies with low interest rates, the masters of the market universe let their trading programs run. At this time of year, that means buying stocks.

The news isn't required to be good. It just has to not be calamitous. So the Standard & Poor’s 500 stock index is up more than 6% thus far this year.

In simple terms that there is nothing to stand in the way of the buy-the-calendar horde. Certainly not equity fund managers, who would rather not give up a home in Tuscany to summer on Coney Island. If they weren't willing to stand up and say the market is too expensive in 1999, when it was insanely overvalued, they aren't going to do it ever.

Besides, these days equity managers drone on and on about how cheap the market is on projected earnings (that the market isn't going to earn, but that's tomorrow's problem and it may not matter anyway).

It certainly isn't going to be the retail public throwing a spanner into the works. If something dramatic were to stampede them into selling, it would be another story. But the public tends to follow the leader and likes to chase last year's returns. Right now, that's the stock market.

Ergo, equity prices will probably continue to rise throughout the quarter, because exhaustive analysis of trading data indicate that, in the absence of a fiscal crisis, stocks rise in the first quarter. Quantitative (black-box) strategies are more and more dominant, in large part because others became weaker. Each time the black-box-centric players, especially hedge funds, buy through the first quarter, then sell in June. Yes, this does raise risk for the system.

There is a momentum psychology at play here. If black box-happy hedge funds all decide that the first quarter is a superb time to buy stocks, then it will be because they’re all throwing money into the market. If they believe that seasonality (such as a conviction that the market does well in January but poorly in September) trumps everything, and act on that belief, then seasonality will appear to trump everything – unless something bigger happens. Bridgewater Associates, the world’s largest hedge fund, throws a few billion at the market, watches prices go up and says: Gee, confidence must be up, so let’s take more risk. Like every other fad trade, the moves get more concentrated until something blows up and everyone loses money at once. Then the hedge funds go back and reprogram.

I expect a pullback soon due to a combination of factors – the weather, the impending sequester of federal money thanks to the latest looming Washington standoff, another rising week leaving the market overextended again and the monthly options expiration, which can produce volatility. Unless the sequester goes really badly, however, it probably won't be more than a pullback.

There are one or two other situations that could pop up and hit the risk-off button with an audible bang, like a large-scale Middle East conflict or Cyprus deciding to take the honest route and admit it's bankrupt, thereby provoking more European Union crisis meetings.

But absent the geopolitical events – which are still worth insuring against – your main preoccupation should probably be deciding what to bail into when stocks swoon in mid-spring, and what to invest in after they bottom in late spring.

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M. Kevin Flynn, CFA, is the president of Avalon Asset Management Company in Lexington, Mass. Website:avalonassetmgmt.com.

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