Wall Street's mettle will be tested next week as traders return from summer to resurfacing signs of weakness after a six-month rally for stocks. Markets closed the first week of the month with the worst weekly performance since early July, though the bulk of losses were recouped Friday as investors deemed the monthly employment report to be less dire than expected. September has historically been one of the nastiest months of the year, a notoriety solidified last year by the collapse of Lehman Brothers, the takeover of Merrill Lynch and the bailout of American International Group. Increased volume this week has investors keen to see what direction the market will take after the Labor Day holiday. U.S. markets will be closed on Monday.
Investors may take heart next week from policymaker pledges to keep easier monetary policy for the time being just as world stocks, testing the sustainability of the 2009 risk rally, face their first weekly loss since July. The outcome of the meeting of G20 finance chiefs in London, a gathering of G10 central bankers in Basel and central bank policy verdicts from Britain, New Zealand and Canada might highlight tensions between countries wanting exit strategies and others warning against them. The rally in world stocks, measured by MSCI, is hitting speed bumps after they touched a 10-month high last week and the benchmark index is on track to post a weekly loss -- only its fifth since March. According to EPFR Global, investors pulled $4.95 billion out of global equity funds in the week ending September 2 and committed $5.06 billion to fixed income funds. "Global equity valuations are not yet stretched, but no longer offer the extreme valuation opportunity that was presented earlier this year," said Tristan Hanson, manager of asset allocation and strategy at Ashburton. Ashburton has just reduced equity weighting to 30 percent from 45 percent. "There will be less downside risk in the event of an equity market correction, something we view as more likely today than a month ago. The possibility of a correction should not be surprising as equity markets have just provided three years worth of returns, or 20 per cent, since the July lows," he said. "The 12 month outlook for global equities is still positive in our view, and there is scope for a significant improvement in corporate profitability...
When we believe another compelling opportunity has arisen to increase equity weightings once again, we will act accordingly." According to Standard & Poor's, all 46 equity markets it tracks have posted gains since January, with 14 markets up at least 50 percent and another 22 markets up more than 25 percent. "On the activity front, the emerging policy view is that the worst is over... But on prospects for recovery, the overriding fear is that it will be weak," Philip Poole, head of emerging market research at HSBC, said in a note to clients. "This combination suggests that central banks in most parts of the world will be in no hurry to withdraw the liquidity that has fed through so powerfully into risk assets, including emerging market assets and currencies, since the Q1 trough."
The debate on exit strategy and the need to support the recovery is high on the agenda of a two-day G20 finance meeting which ends on Saturday and a gathering of G10 central bank governors on Sunday and Monday in the Swiss city of Basel. Sources have told Reuters the G20's communique, due on Saturday, will likely maintain the pledge to keep policy accommodative for as long as was needed. None of the central banks in Britain, New Zealand and Canada is expected to change their monetary policy. Investors are braced for warnings from these central banks against discounting for imminent rises in interest rates following surprisingly dovish comments from their counterparts in Australia and Sweden earlier this week. SUSTAINABILITY TEST Concerns about how sustainable this year's rally is are similar to early 2002, according to Goldman Sachs, when an inventory-driven rebound and a sharp market rally after 9/11 gave way to a softer growth profile and a renewed market decline.
However, the U.S. bank warns it is too early to conclude that momentum is fading. For example, a valuation picture is better now than 2002, when the market suffered from a serious valuation overhang. Cyclically-adjusted price-earnings ratios for the S&P 500 index stands at 17 now, compared with 30 in early 2002. "While we agree that sustainability of recovery will be a key theme for the remainder of the year, we think the latest worries are likely (again) to prove premature," the bank said in a note to clients. Goldman has upgraded the year-end forecast for DJ Stoxx 600 to 260 from 235. Its 12-month target for the index is 275.
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