Can The Market Continue To Grow In 2011?

By Stephen D. Simpson, CFA | December 29, 2010 AAA
Can The Market Continue To Grow In 2011?

With only a few trading days left in the year, the market is poised for another year of double digit growth. Not only is a low-teens return solid in its own right, but it continues the recovery from the lows of early 2009. That said, the market has nearly doubled from those lows and it is hard to see how the market has not overshot the actual level of economic recovery in that time. The question has to be asked, then - can the market continue to grow in 2011? (For more, check out 2010's Highest Performing S&P 500 Stocks.)

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The Bad: Debt, Debt, Everywhere
Simply put, there is a lot of debt out there right now. The U.S. federal government has been borrowing heavily to finance ever-larger deficits and state and local governments likewise find themselves straining under debt obligations taken on during the best years of the housing bubble. As Iceland, Greece and Ireland have ably demonstrated, there comes a point in time where debt can no longer be ignored or indefinitely rolled over.

Whether or not the U.S. is close to that point, the fact remains that increasingly difficult decisions are on the docket for governments. Governments have two choices in dealing with debt (assuming that simply not paying it is not really a valid choice) - cut spending or raise taxes. Neither would be good for the markets or investors in the short-run, though an argument can be made that lower spending would be "less bad" as private companies could step in to offer those services at perhaps a lower overall net cost to consumers.

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The Bad: Easy Money and Inflation
Perhaps paradoxically, the U.S. Federal Reserve has been fighting hard to keep money cheap even though the government already has too much debt and commodity costs are on the upward march. While the Fed has pointed to signs of low and unstable growth as well as the risk of deflation as validation for the policy, eventually there will be a price to pay. Cheap money always comes at a long-term cost; the most common of which is high inflation. By the same token, the Fed is clearly terrified of the risk that turning off the spigot and letting rates rise would choke off the economic recovery. Ultimately, this is probably more of a perception issue for Wall Street than a fundamental issue - fighting deflation made sense at the time and there has been so little growth in employment and wages that it seems hard to imagine that inflation has taken hold in the United States. (To learn more, see Deflationary Stocks: Helping Or Hurting The Economy?)

The Good: Slack in the System
Though the economy has clearly rebounded from its worst levels, there seems to be plenty of room left to grow. U.S. rail traffic is still well below the levels of 2006-2007, steel prices are still well off peak levels and factory utilization is more than 6% below 2007 levels. On top of that, employment has not yet recovered and companies have been very slow to add capacity. To the extent that governments don't foul things up with misguided policies or direct interference, then, there may be many years of gradual recovery left before any sort of "new normal" becomes relevant.

The Good: Higher Commodity Prices
It may seem insane to point to higher commodity prices as a positive for the stock market, but there is at least some method to the apparent madness. Commodity prices move up when there is a demand for those commodities, and a lot of the commodities that people mean when they talk about commodities are industrial inputs. True, nobody wants to see the price of oil, copper or lumber rise to levels that choke off growth again, but it is not an either/or sort of argument. While many industrial companies would be happy to see prices fall due to greater supply coming on line, that's a multi-year process and for now it seems that demand drives the price. Accordingly, higher prices may not be all that bad

Valuations, VIX, and Volatility - Oh My!
Certainly there are ample reasons to be nervous about the market. VIX has moved to levels that suggest complacency and the P/E ratio on the S&P 500 is well above "median" levels. On the other hand, major sectors like healthcare and financials have been struggling and have not seen earnings rebounds to the extent that technology or industrial companies have. In other words, leadership could cycle between sectors and industries and the overall pace could still be positive.

What's more, there is still a lot of worry in the market. Gold bugs are convinced that they're sitting in the only seats that will be around when the music stops, and there are widespread worries about inflation, municipal and federal debt, and the potentially contagious effects of further sovereign crises in Europe. Ultimately, that is a good thing - it is when people stop worrying and stop looking over their shoulders that bubbles reach their final stage and the markets tumble. Consequently, while 2011 will likely not be as strong as 2010, there is both enough potential in the system and pessimism about that potential for stocks to move higher. (Check out Financial Resolutions For 2011 to get ready for the New Year.)

For the latest financial news, see Water Cooler Finance: Canadian Takeover And U.S. Tax Breaks.

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