Market Outlook August 22, 2011

Markets behaved over the past week in almost the opposite way of the week before. Instead of consistently rising over five days, they consistently fell over five days. This is to be expected during periods of high volatility. (The VIX is at 43.05.) It was rumored that Warren Buffet was buying during the market weakness two weeks ago, and there were probably others also putting cash to work. As that extraordinary demand ended, markets continued their decline. Strangely, my fair value estimate of the stock market increased again this week. For the first time since the recovery beginning in March 2009, the indicator is showing the market as slightly undervalued. The market is discounting 12-month earnings growth of just 2.00%. This probably explains Mr. Buffet’s eagerness to buy.

Inflation dropped from 3.1% last month to 2.7% this month. That makes it less likely that interest rates will rise, thereby reducing one risk that would cause economic growth to slow. As difficult as it is to believe, bond yields fell as buyers drove prices up. The real yield (after inflation) is very close to zero, making bonds simply a safe place to park money. Bonds continue to have far more momentum than stocks, making bonds the preferable investment to overweight at this time. The ultimate safety, gold, reached a new high this week. My asset rotation strategy continues to signal to own gold (IGT). That choice served us very well once again, over the past week.

Are we heading for the second dip of a “double dip” recession? Is this the early 1980s all over again? It could be, there are many similarities: poor stock market performance, strong demand for commodities, gold on a tear, but interest rates are extremely low instead of extremely high. Recall, also, that markets tend to be weaker during summer months and that weakness often reaches its nadir in September or October. There’s a chance (optimistically) that buyers may simply be holding off for a couple months, and markets may turn upward in November, despite the tone of economic news.