Investors might want to keep their seat belts buckled for a little while longer.
Since the beginning of October, stocks, commodities, the euro and other assets that benefit in good times have staged a blistering rally, reversing some of the third quarter's punishing losses.
Since bottoming Oct. 3, the Dow Jones Industrial Average has jumped more than 9%, while the Standard & Poor's 500-stock index was up more than 11% as of Friday's close. In France, the CAC 40 index is up 18% from its low in late September. Crude-oil prices have risen 15% since Oct. 4, copper is up more than 8%, and the euro rose almost 4% against the dollar last week.
Another sign of the stunning turnaround: U.S. Treasurys, which had been a helter-skelter destination for safety-seeking investors, have seen prices collapse.
Nevertheless, many market strategists and investors remain wary. Their concern: The fate of global financial markets is largely in the hands of government officials in Europe and the U.S. That has thrown many investing tools out the window. Investors can no longer bank on the economy or company earnings as key drivers of financial markets.
"Investors should not let their guard down just yet," Chen Zhao of BCA Research, a Toronto-based firm, wrote in a note to clients Friday afternoon. "The direction of the stock market will be dependent on how policy makers in Europe react to the brewing banking crisis. Unfortunately, it is impossible to predict a political process that is as clear as mud."
Tony Crescenzi, portfolio manager at Pacific Investment Management Co., sees the markets potentially stuck in a "quasi state of purgatory."
The first real test will come Oct. 23, when European officials are expected to officially advance a proposal to bolster the balance sheets of the continent's battered banks. The risk is that, when the details are ironed out, Europe's latest crisis-ending plan will once again fall short of investors' hopes. That happened in July, when European officials failed to live up to expectations for a comprehensive resolution to Greece's debt.
Also looming is the Nov. 23 deadline for a U.S. congressional super-committee to agree on a plan to find more than $1.5 trillion in budget savings.
Add it all up, and "we're very cautious, particularly on the equity-markets side," says John Richards, the head of strategy for the Americas at RBS Global Banking and Markets.
A major catalyst for this month's big rallies has been relief that Europe is at long last turning attention to its banks, many of which have big holdings of debt from fiscally strapped countries such as Greece, Italy and Spain. Another optimistic sign has been a string of stronger-than-expected reports on the U.S. economy, including Friday's gain in retail sales. While the economy still is struggling, there is evidence it may avoid dipping back into recession. "In the last two weeks we've seen a fairly significant shift…away from the U.S. recession and related meltdown types of scenarios," said RBS's Mr. Richards.
Michael Aronstein, a co-manager of the $700 million Marketfield Fund and chief investment strategist for Oscar Gruss & Son, is one optimist who thinks the markets have largely factored Europe's woes into prices. "Europe's news is pretty thoroughly understood by the market," to the point where it has become "cocktail party chatter," he says.
But Erin Browne, director of global macro trading at Citigroup, says the sudden shift in sentiment came just after investors became heavily bearish on stocks. Much of October's stock buying has come from those trades being reversed, she says. Many of the big gains came on days of low trading volume, suggesting little buying from big institutional investors that would reflect greater confidence in the rally.
"People are still very skeptical that there will be a holistic solution in Europe," Ms. Browne says. But with European officials actively working on a bank recapitalization plan, even skeptical investors "don't want to be 'short.' " Others also appear to be easing off their most defensive positions. However, given the potential pitfalls that could still waylay the markets, many strategists and investors are keeping portfolios light on the riskiest investments.
For now, the devil will be in the details for the markets. The crucial question is exactly how banks will raise the cash they need. If the plan leans heavily on government money, it could fuel worries about cash-strapped Italy and Spain, while deepening concern that France could lose its triple-A credit rating.
And if the banks have to fend for themselves, it could fuel more volatility in financial markets, says Jens Nordvig, currency strategist at Nomura Securities. Such a move, he says, could lead to a pullback in bank lending at a time when Europe is already flirting with recession.
In the U.S., attention has been on the economic news. That could change as the super-committee's budget deadline nears. Even if the panel comes to an agreement, some worry the deal won't be enough to avoid another cut in the U.S.'s credit rating.
"This is a critical issue, and by no means are we sanguine that it's going to come out favorably," says RBS's Mr. Richards.
Two weeks ago Mr. Aronstein exited from a "good-sized" position in 30-year U.S. Treasurys and has ramped up his holdings of stocks to the highest levels in months. While he is short some financial stocks—he compares some banks' business models to those of railroads 60 or 70 years ago—he sees opportunities in manufacturing, technology and some consumer-discretionary stocks.
"People are in the mood to be frightened," he says. But there are "a lot of stocks, in particular in the U.S., that are doing well."
On the other hand, Jeff Applegate, chief investment officer at Morgan Stanley Smith Barney, calls the recent bounce a "relief rally" that won't last long. Last week, he made his biggest bearish shift in two years, reducing his recommended holdings of stocks, high-yield bonds, commodities and real-estate investment trusts. Mr. Applegate says the world is heading into recession, hurt by political paralysis and the withholding of fiscal stimulus at a time of economic weakness. The past few weeks haven't changed that outlook, he says."The policy action being taken, both in Europe and the U.S., is too little, too late," he concludes.
