Market Outlook November 7, 2011

Last week I was relatively optimistic, but the stock market is 1% lower this week. It doesn’t look like it’s headed down, but it doesn’t appear to be in recovery mode yet, either. Actually, the market dropped almost 4% between the close on Oct 31 and the open on Nov 1. The climb since then has been steady, which is exactly what seasonality would predict.

Momentum this week has continued to improve, but is still not greater for stocks compared to bonds. In fact, bond yields fell quite a bit over the past week, as investors looked to bonds for a safe haven. Bond values rose more than 1.6% over the past week. In a portfolio split between stocks and bonds (and cash), bonds continue to appear more favourable. Asset rotation, however, continues to prefer gold (IGT), with small caps, then emerging markets, showing well.

The economy looks less certain than in the past. This isn’t new news, of course. Newspaper headlines continue to magnify every problem and hiccup. On balance, that entails far less risk than ignoring the problems, while headlines encourage everyone to invest in the latest hot pick. Inflation, at 3.2%, is higher than the Bank of Canada’s target band between 1% and 3%. Even inflation expectations have crept up over 2%, which is worrisome. At least the term spread is steep enough to be profitable for banks.

The stock market continues to appear slightly undervalued. My fair value calculation gives a range between 9,800 (extreme pessimism) and 16,400 (extreme optimism). The upper range continues to rise as earnings are reported. The market value was near this upper limit while the market recovered from the 2008-2009 crash, but is currently very near the mid-point. I think that it optimism will need to become widespread before the market produces very good growth.