Equities 2012: The Sound of One Hand Clapping

The books have just closed on the third quarter, and it was a very good one for equities of virtually all stripes. The broadest measure of the domestic market, the S&P 500 Index, enjoyed a total return (including dividends) of 6.35% in Q3. That’s impressive, but what’s even more impressive is that despite a plethora of exogenous negatives, the smart money has continued to bid stocks up virtually all year.

Through the first nine months of 2012, the S&P 500 has surged nearly 15%. That’s better than stocks in the Dow Jones Industrial Average, but they too have seen great gains. The Dow is up 10% through the first three quarters of the year, a very robust gain for the 30 bellwether stocks in the large-cap index. As for stocks in the NASDAQ, well, that’s where the real gains have been seen. So far in 2012, the NASDAQ Composite is up 19.5%. As for the top-tier stocks in the index, the NASDAQ 100, their climb has been an extremely impressive vaulting of nearly 23% year-to-date.

Now, despite what can be described as a stellar year so far for equities, there remains a very cautious undercurrent as to whether this year’s bull market is something that’s real, or whether it’s all just smoke and mirrors. Indeed, the presence of skepticism that lies thinly veiled beneath this market’s bullish façade is something that I haven’t seen in my nearly two decades of professional market participation. That skepticism is largely why there remains some $6.9 trillion still in savings accounts, despite record-low interest rates.

There are many valid, and acutely rational, reasons to remain unconvinced that this rally is anything but an evanescent circumstance. Perhaps the biggest reason why is that the gains in stocks since June have largely been fueled by the promise that the world’s two most powerful central banks — the Federal Reserve and the European Central Bank (ECB) — would come to the rescue with plenty of funds to backstop any slide in the global economy.

In ailing Europe, where recession is a reality and where the European Union faces the very real risk of dissolution and a potential collapse of the euro, all eyes were on the ECB to bailout countries like Greece, Italy and Spain. The ECB did just that in early September, with its announcement of “OMT,” or outright monetary transactions, which essentially is a plan to buy bonds in order to keep down sovereign yields. In the United States, Ben Bernanke and his band of central bankers did even more than most on Wall Street were anticipating, pledging to keep buying $40 billion worth of mortgage-backed securities each month for an unlimited period.

Paradoxically, the need for the Fed and the ECB to step in and unleash the easy-money hounds also is de facto acknowledgement that the fundamentals in the economy are so poor that massive rescue operations are needed to save, jump-start, and otherwise take some type of action to cure an ailing patient. So, while unlimited monetary easing and outright bond buying may be what the markets want (the markets always want access to cheap capital), the precarious conditions leading to the necessity of such action is more than enough to make even true believers skeptical of this market’s ability to sustain the 2012 gains.

This market’s action reminds me of a famous Japanese kōan that reads: “Two hands clap and there is a sound. What is the sound of one hand?”

In market speak, the question could be rephrased to: “What do you get when the market surges to multi-year highs, yet there’s so much fear and skepticism surrounding the move that the average investor still is largely in cash and on the sidelines?

You get the sound of one hand clapping.

Until the underlying fundamentals of the global economy are such that central banks no longer feel the need to pump things up, any rally will likely be applauded with only one hand.

Follow Jim on Twitter: @Woodsish.