The Dow Jones Industrial Average and S&P 500 have staged impressive rallies to begin 2012. As of this morning, the Dow was up more than 6% YTD. Improving economic data and a flood of global central bank liquidity have helped levitate stock prices. Volatility has also declined markedly in recent weeks and now sits at an eight month low. As stock prices have risen, economic data has improved, and volatility has dropped, investors have become more bullish. Our chart on the spread between the percentage of bulls and bears in the American Association of Individual Investors sentiment survey is in euphoric territory.
Is the bullish sentiment justified? Have the threats to global economic and financial stability that plagued the market for much of last year been neutralized? When central banks flood the global monetary system with trillions in liquidity anything is possible, but if you look carefully, there are signs that risks remain.
The chart below shows the ratio of the Dow Transports to the Dow Industrials. Transportation stocks are often a leading indicator of economic activity. You have to move the goods before you can sell them. The big down leg in the relative performance of the transports over recent weeks signals trouble. When the transports have plunged relative to the industrials this badly in the past, the broader market often sold off in subsequent weeks. There is no guarantee that the broader market is poised for a correction, but without improvement in the transports caution is warranted.
The oil market is another source of concern for investors. Oil has risen almost 10% in February to a nine month high. The spike in oil prices has come despite recent cuts to 2012 oil demand growth projected by the International Energy Agency. If oil prices aren’t up because demand is rising, supply must be the issue. Is the oil market telling us that a conflict with Iran, the world’s fourth largest oil producer, is imminent? Let’s hope not. The global economy would likely suffer if Iran’s oil supply was cut off. (Read More In: The Looming Threat to Gas Prices: Strait of Hormuz Explained)
Don’t use the powerful stock rally off of the October lows and the strong start to 2012 as an excuse to throw caution to the wind. Successful investors evaluate risk before return. And risks to global economic and financial stability remain.
Jeremy Jones, CFA
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