At their lows near the end of September, U.S. stocks were off about 12% from their May highs, Canadian stocks were down 20%, Germany had lost 24% and Chinese stocks had dropped over 35%!  Following on the worst quarter for stocks since 2011, it seemed reasonable that they would have a bounce back in October and we positioned accordingly by covering (buying back short) positions in our Hedge Fund and adding stock exposure throughout our managed accounts, buying energy, basic materials, technology and health care names.  Stocks bounced back even more than we expected in October, with markets outside of Canada posting the strongest monthly gains since 2011.  As seen in the table below there were some huge moves, with Germany leading the way, gaining 12.3% and recovering close to 40% of the losses from the peak in April of this year.  U.S. stocks were strong, with the major averages all showing monthly gains of over 8%.  Emerging Markets also stormed back, gaining 7.0% after falling 18.5% in the 3rd quarter.  Japan was exceptionally strong despite holding back on further monetary easing for now.  The Nikkei225 jumped 9.7% in October after falling 14.1% in the 3rd quarter.  The overall MSCI Global Stock Index jumped 7.8% in October, the best single month since October 2011, when it gained over 10% after falling over 17% in the 3rd quarter of 2011.  Canadian stocks, however, lagged the global move, but this time around it was not because of the resource sector.  Energy stocks moved ahead 7.5% in October and Basic Materials jumped 7.0%.  The meagre 3.2% gain in the Canadian Financial Services sector and the 9.2% drop in the Health Care sector limited the TSX’s overall gain for October to just 1.7%.

Market Performance as of October 30, 2015

Despite the strong returns last month, though, investors had to resort to the old ‘playbook’ to get the stock rally started.  The ‘bad (economic) news is good (stock market) news’ trade was in full force in October, with investors once again believing that weaker growth increases the chances the central banks across the globe will continue on with their Zero Interest Rate Policies (ZIRP) which, in turn, will support higher stock valuations.  Here’s how the trading pattern unfolded last month:  Stocks actually bottomed on September 28th as they re-tested the August 25th lows.  Then, on October 2nd, the closely-watched U.S. employment report came in well below expectations and stocks rallied further, with investors believing that there was no way the U.S. Federal Reserve would be raising interest rates this year with the economic data deteriorating.  While 3rd quarter earnings reports were certainly not a disaster, they were down on a year-over-year basis.  While many companies beat the expectations on the bottom line, the key revenue line continued to miss.   Moreover, many companies guided to lower results in the fourth quarter, blaming the depressed outlook on currency issues, a slowdown in China and continued weakness in other emerging markets which has contributed to a collapse in commodity prices.  Even the Federal Reserve was worried, citing the exchange rate effect on the economy as a factor in its decision in September to delay “lift off” on raising U.S. interest rates.  The Fed’s inclusion of its concerns about international developments in its September statement flustered markets however.  Seven years of extraordinary fiscal and monetary stimuli are proving ineffective towards achieving the growth and inflation targets laid out by the Federal Reserve.  The primary success of these ZIRPs has been to lift stock prices, particularly in the U.S., as amply demonstrated by the October rally.  This is because stock prices, in our view, have become dependent on massive and ever increasing amounts of quantitative easing (new money creation) to stave off slower revenue growth and support earnings enhancements such as aggressive stock buybacks funded by low interest debts.  But, like addicts that need increasing amounts to feed their addiction, it isn’t much of a mystery that the major U.S. stock averages have gone nowhere since QE officially ended in October of 2014.

The following chart shows how the impact of ‘zero rate policies’ has been wearing off.  The U.S. Liquidity Index shows the growth in funds (liquidity).  Global Liquidity Indexes (GLI) are comprehensive monthly surveys of carefully selected financial variables.  They provide an advance indicator of ‘financial stress’ or what will happen to financial markets and the real economy by tracking data on credit spreads, available funding, cross-border flows and Central Bank interventions across some 80 countries worldwide.  When the growth in the broad index drops below the economic growth rate then we are defined as being in the ‘Danger Zone’ for a financial ‘accident’ of some sort.  We clearly moved into that zone in 2007 in advance of the financial crisis and were close again in 2011 during the Eurozone crisis.  We entered back into this territory again earlier this year.

But stocks continued to rally nonetheless in October as ECB head, Mario Draghi, once again came to the rescue, giving a clear nod to further stimulus coming soon to add to their existing easing program.  The ECB head hinted that hundreds of billions of Euros of extra quantitative easing bond purchases and an even deeper negative deposit could be used to accelerate growth in the Euro region.  The fact that the ECB was about to unleash even more monetary stimulus sent the Euro and bond yields lower while supercharging European stocks.  Then China’s central bank (PBOC) surprised investors by cutting interest rates for the sixth time in less than a year, citing the need to boost economic conditions and lending.  China unexpectedly cut its benchmark one-year lending rate by 0.25% to 4.35% and lowered the reserve requirement ratio for all banks in a bid to lift a sagging economy.  The surprise move lifted risk assets that had been already boosted by the prior day’s message from the ECB.

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