Any day now, the S&P 500 could close at a new all-time high. To anyone reading the headlines this week, this might seem like madness. The sequester goes into effect today, which will likely chop a full half percentage point off of GDP growth, and we just had a parliamentary election in Italy that threatens to send Europe back into crisis. And capping it all off, the Fed recently told the world that the “QE Infinity” might be finite after all.
Yet the market marches higher. Are investors delusional?
Not necessarily. Let’s start with the sequester. This is the most anticipated “crisis” in history. This first popped up in the summer of 2011 during the debt ceiling negotiations. You know, the ones that caused us to lose our AAA credit rating with Standard & Poor’s.
The worst aspect of the “fiscal cliff” compromise was the potential tax hike, not the government spending cut. But we already dealt with the tax hikes, and the market has had time to digest their effects. The sequester will hit the defense industry hard, and there will be some knock-on effects from job losses and hour reductions. But otherwise, this is a crisis that generates a lot of news headlines but not much else.
Europe is trickier. European stocks had a bloodletting on Monday and early Tuesday when news started trickling in from the Italian election. The market had hoped for left-center coalition that would continue the reforms and austerity policies of outgoing prime minister Mario Monti. But a stronger than expected showing from a crook (Silvio Berlusconi) and a comedian (Beppe Grillo)left Italy with a hung parliament that will be too weak and divided to do much of anything.
Over the course of the week, European stock prices gained back most of their losses.
What’s going on here?
It is really quite simple. Things are bad out there, but not as bad as they were. The market had already priced in so much bad news over the past few years, that events that might have caused a bear market a year ago get barely a shrug today.
But more than anything, the confidence that the Fed and ECB instilled last year has been maintained. For now, investors take ECB President Mario Draghi seriously when he says he will do “whatever it takes” to preserve the Eurozone. And even in the case of Italy, there is now a precedent in place for coping with a leadership crisis. A technocratic prime minister was installed when Italy’s politicians couldn’t get the job done. This can be done again if conditions get bad enough.
In the meantime, I don’t recommend fighting the trend. Stay invested, with the foundation of your portfolio in dividend-paying stocks (VIG), master limited partnerships (AMJ) and REITS (VNQ).
To protect your portfolio, use a stop loss order or a trailing stop. And if you want to be extra cautious, you can tighten your stops to 5-7%. But don’t let the headlines scare you out of what is potentially the strongest bull market we’re going to see in a long time.
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