Markets rally strongly in first quarter

Markets mostly completed a highly profitable quarter at the end of last week.

Stocks in the United States rose last week, with the Standard & Poor’s 500 Index rising 0.8 percent to 1,408.47. The index rose 12.0 percent in the first quarter, the biggest first-quarter rally since 1998.

Stocks in Europe fell last week, with the STOXX Europe 600 Index falling 0.9 percent to 263.32. Nevertheless, for the first quarter, the index rose 7.7 percent, the best first quarter gain since 2006.

Asian stocks rose last week, with the MSCI Asia Pacific Index rising 0.2 percent to 126.60. The index rose 11.2 percent in the first quarter, its biggest quarterly gain since September 2010.

Buoyant sentiment was less evident in commodities. The Thomson Reuters-Jefferies CRB Index gained just 1.0 percent in the first quarter after falling 4.3 percent in March.

The performance of the index, though, was mainly dragged down by natural gas, which fell 28.9 percent in the first quarter as a burgeoning US gas inventory pushed prices to 10-year lows.

However, most other commodities saw price increases in the first quarter. US crude oil rose 4.2 percent in the first quarter despite a 3.8 percent decline in March. Gasoline jumped 26.2 percent in the first quarter.

Improved risk appetite over the past three months meant that while stocks and commodities rose, bonds fell. US Treasuries suffered their worst quarter since the last three months of 2010, with the yield on the 10-year note rising 33 basis points to 2.21 percent and the yield on the 30-year bond rising 44 basis points to 3.34 percent.

The rally in markets has been widely attributed to monetary stimulus by central banks around the world, particularly the Federal Reserve and the European Central Bank. The question for investors then is: How long can central banks keep stimulating markets?

Barry Ritholtz at The Big Picture has a post with a chart taken from LPL Financial showing how each of the Fed's monetary stimulus programme over the last few years boosted the stock market. As soon as the stimulus from one programme faded, the Fed introduced another one, thus keeping the market rallying.

So clearly central banks can maintain the stimulus for a considerable period of time.

However, it is unlikely that they can keep this up once overvaluation of markets becomes extreme. Remember that the stock market collapsed in 2001-2002 and 2008 even while the Fed was cutting interest rates.

As John Hussman of Hussman Funds remarks in his latest weekly commentary: “The only real choice policy makers have is how large a bubble they choose to see collapse.”

Having said that, Hussman notes that markets are not as overvalued now as they were at the peaks of 2007, 2000 and 1929. Citing the work of Andrew Smithers, Hussman says that the market is now overvalued by 70 percent. He expects an average annual nominal total return of 4.1 percent over the coming decade.

Hussman also says in his commentary that high profit margins, which some analysts have used to justify the higher stock prices, will not save stock markets. This time citing the work of James Montier at GMO, Hussman says that the increase in corporate profit margins has come at the expense of government and household savings, which have been deteriorating over the same time period.

He says this is unsustainable and that “any deleveraging of presently debt-heavy government and household balance sheets will predictably create a sustained retreat in corporate profit margins”.

Still, you may not want to bet against a continuation of the rally just yet. As Ritholtz pointed out, Fed Chairman Ben Bernanke has shown himself to be willing to provide whatever stimulus markets have demanded. “The traders on the street,” he said colourfully, “know exactly how to throw a hissy fit. They are happy to whack the market 20% to get Ben’s attention, and he seems happy to give them their binky to make them stop crying and go back to their cribs.”

Of course, the real crying may start when the next round of monetary stimulus turns out to be as effective on markets as the ones in 2001-2002 and 2008 were.