This past week was a good one for stocks. They rose over 2% during the week, while bonds fell in value again. Whereas a week ago, it was difficult to tell if stocks were maintaining their momentum, or if they were sliding back into weakness, this week the momentum of stocks (compared to bonds) is once again reasonably positive. A portfolio that is balanced between stocks and bonds should continue to favour stocks.

Asset rotation has been volatile over the past couple months. Last week (which I forgot to post), momentum favoured European stocks (FXI). That surprised me, but they performed well and they continue to offer the greatest momentum. US small caps have been very disappointing. Among Canadian asset classes, large caps (XIU) continue to show the best momentum. That implies that indexing is working very well right now.

The likelihood that the economy is moving into a bear market has become more remote. This is based on the perspective of interest rates rising as the economy strengthens, causing the economy to sputter and stall. That hasn’t happened, since interest rates haven’t risen. The economy appeared the strongest near the beginning of 2012, but far from overheating. If we were to move into a recession now (4 or 5 years after the last one would approximately fit the business cycle), it would feel like we missed the recovery and peak stages of the business cycle.

Based on corporate earnings, which are starting to be reported, and the dividend yield, the TSX continues to appear almost 10% overvalued. This suggests caution. Although stocks have some momentum, chances are slim that they’ll start a smooth increase in the near term.

Market Outlook October 22, 2012

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