I spend about 15 minutes a year on economic analysis. The way you lose money in the stock market is to start off with an economic picture. I also spend 15 minutes a year on where the stock market is going. All these great, heady, thinking deals kill you.

It’s uncanny how often people feel most strongly that stocks are going to go up or the economy is going to improve just when the opposite occurs. Worries based on economic predictions are particularly useless. The GNP six months out is just malarkey. Stand by your stocks as long as the fundamental story of the company hasn’t changed. How is the sneaker industry doing? That’s real economics.

—Peter Lynch, Legendary Fund Manager at Fidelity

Superstar investor Peter Lynch voiced these words more than a decade ago, but 2012 has proved to be the best example yet of how worrying about the economy can ruin your investment results. At the start of this year, the wall of worry was thick and tall:

(1)   The Economic Cycle Research Institute (ECRI) was forecasting a US recession.

(2)   Wall Street analysts were forecasting a significant slowdown in corporate profits.

(3)   Europe’s debt crisis had already caused a eurozone recession and was threatening to collapse the euro.

(4)   China’s economy was slowing and in jeopardy of suffering a hard landing.

(5)   Iran’s nuclear program was provoking a war with Israel that could cause the price of crude oil to spike to $300 per barrel.

Understandably, many investors were hesitant to risk hard-earned capital in the stock market, but those who hid their money under a mattress have been the losers. Look at the statistics year to date:

• Germany’s DAX Index up 17.7 percent
• Nasdaq Composite up 16 percent
• S&P 500 up 13.3 percent
• West Texas Intermediate (WTI) Crude Oil down 6.1 percent

When looking ahead to 2012, most people were bearish on stocks and bullish on energy, which was the exact opposite of what actually happened! Bottom line: No matter how “sure” you are that something bearish or bullish is going to happen, it pays to be humble and hedge your bets in case your hunch turns out to be wrong–as often happens. 

Trying to predict the economy is impossible and misleads more often than enlightens, so I almost feel that I shouldn’t discuss the economy at all. After all, did my repeated mentioning of ECRI’s recession call help any Investing Daily reader make money? I doubt it. On the other hand, isn’t relevant information about the economy worth something? I still believe that it is better to be educated and aware of what’s going on in the world than ignorant. The key to investment success is to remain agnostic and humble about the future and not deviate from your long-term investment plan based on an uncertain short-term forecast. Furthermore, it pays to remain optimistic about the long-term wealth-generating power of stocks, historically the best-performing asset class by far (compared to bonds, cash, or gold).

It’s Fun to Engage in Future Babble

All that said, let’s talk about the economy and stock market! The “risk on” trade is back in full force:

• US stocks and emerging market stocks are both at three-month highs.
• The S&P 500 has risen for six consecutive days, five consecutive weeks, and eight of the past 10 weeks, gaining 11 percent since the June 4th bottom. That’s the best first seven months since 2003 and the second-best seven months since 1998.
• The S&P 500 has broken above 1,400 (1,405.87) and is very close to its 52-week high of 1,422,28 on April 2, 2012, not to mention being only 10 percent below its all-time closing high of 1,576.09 in October 2007.
• The upward trajectory of long-term US Treasury bond prices has stalled and could be entering a correction phase as fears of an imminent euro collapse and US recession subside. The price of the iShares Barclays 20+ US Treasury Bond ETF (NYSE: TLT) has fallen from $132 to $124.

Stock Market’s Bullish Trend Will Continue

For the S&P 500, the question is whether its current rally above 1,400 toward the April 2012 high of 1,422 will break through to new highs or hit resistance as part of a double-top formation. While there may be some consolidation and a short-lived pullback near the April highs, I’m leaning toward an eventual breakout to new highs for a few reasons:

• The weekly MACD crossed above zero on July 20th and is still rising.
• The relative outperformance of defensive industry sectors vs. the S&P 500 has topped and is reversing, which means cyclical sectors are ready to take the lead. This usually happens only during bull markets. 
• AAII investor sentiment has rebounded after hitting a two-year low, which suggests retail investors’ appetite for risk is returning.
• Presidential election years are historically strong during the last seven months.
• Moderate US economic growth appears likely to continue, based on good July employment figures (most hiring in five months) and record-high June exports. Even the year-over-year growth rate on ECRI’s Weekly Leading Index (WLI) is currently at a nine-week high!
• Quantitative easing for both the US and Europe is likely to occur.

Europe’s Draghi Promises Monetary Stimulus

I’m confident about more quantitative easing in Europe because European Central Bank (ECB) President Mario Draghi virtually promised it when he said on July 26th:

The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

Some analysts don’t believe him, and the ECB’s decision not to lower its benchmark interest rate at its August 2nd meeting supports some skepticism. But Draghi did announce at the ECB meeting that a plan to buy more government debt of financially weak eurozone countries (e.g., Spain) was in the works. Based on the rallies in European stock markets since Draghi’s July 26th comment, hope apparently springs eternal that Draghi will follow through on his promises to save the euro.

Federal Reserve Hints at QE3

In the US, individual Federal Reserve regional bank presidents continue to disagree on the wisdom of a third round of quantitative easing (QE3), with Boston President Eric Rosengren in favor of such an action and Dallas President Richard Fisher opposed to such a move. Both are non-voting members in 2012, but Boston becomes a voting member in 2013, whereas Dallas has to wait until 2014, so Rosengren’s pro-QE3 view is closer to the levers of power right now and therefore more important. Even more noteworthy, however, was the shift in language between the Fed’s June 20th and August 1st rate announcements. June’s statement said the following:

The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

By contrast, August’s statement was more detailed:

The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

According to Fed watchers, the phrase “closely monitor” is a code word for action. The question is whether this action will take place at the September 13th or December 12th Fed meeting (the October 24th meeting is too close to the presidential election). Regardless of when the monetary stimulus occurs, the fact that QE3 is probably coming (at least a 60 percent chance) will keep both stocks and gold in bullish mode through the end of the year.

The Road to Higher Stock Prices May Be Volatile

This does not mean, however, a smooth ride for the market, and I expect a few scary drops along the way to higher prices thanks to continued Middle East tensions and concerns about the January 2013 fiscal cliff. The S&P 500 Volatility Index (VIX) is trading at only 14.50, which is incredibly low and unsustainable even if we are entering a “low VIX” era (I’m not convinced that we are).

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