TimingCube - And back again - QE2, stock rally, active ETF

Fundamentals - stocks have been very news-driven in recent weeks. During the market's pullback in May and June, investors were battered almost daily with diminishing economic expectations grouped into a scenario called a "soft patch" in the economy. That's presumably better than last summer's "double dip" worries, as markets never even fell the 10% required for a true correction. A stronger-than-expected manufacturing report was the catalyst to break this soft patch notion and help put stocks back on firmer footing. This gives investors optimism that corporations will deliver a strong batch of earnings reports once more.

The other primary source of concern during May-June was the ever-deteriorating Eurodebt situation. Eventually, a series of events occurred to resolve this in favor of stocks, at least temporarily. The German Parliament, French banks, and Greek government all did what they had to in order to deliver the next chunk of working capital to Greece. This chain of events appears to have helped stock investors ignore the fact that bond markets continue to punish southern Europe government bonds as rating agencies tighten the noose. Given that little has fundamentally changed in the Eurodebt situation over the past year or so, investors can be assured that further fires are ahead in this area.

Finally, investor concerns that the U.S. Congress and Administration will fail to raise the debt ceiling appears to have been assuaged. This helped support investor confidence as well. Were this situation to backpedal, expect investors to get real nervous real fast as the uncertainty surrounding the implications of the debt ceiling would be huge.
Emotion/Sentiment - During the deluge of negative news in May-June, Investor sentiment plunged to levels not seen since last summer (remember pre-QE2?). The turn of fundamental events outlined above coupled with technical market support holding helped investors feel more comfortable committing money to risk investments. Initially, it was just a handful of momentum trading stocks receiving the money. As happens during rallies, the circle of favored stocks grew ever-wider until the broader indexes were carried higher. Investors who were shorting stocks, betting on a further market decline or just having bought insurance to protect their portfolio, sense the emotion underlying the market is turning away from Fear. They buy back shares to close out their short position, adding fuel to the rally by doing so. With each passing day of the rally, more and more investors worry they are being left behind and dive into the fray. In this current rally, this ever-increasing rush into stocks gave us eight straight positive days for the Nasdaq Composite and pushed our Classic Model to embrace the rally with a Buy earlier this week.

Thanks to the intense emotional reactions to investing money, markets almost always overreact pushing stocks too far higher or lower than fundamental events would suggest. We've pointed out on numerous occasions that the P/E ratio is a good indicator of this emotion and sentiment. In a secular bear period, such as we've been in for over ten years now, slowly degrading investor enthusiasm for investing in stocks causes P/E ratios to trend downward. Thus, pointing to long-term P/E ratio averages of 15 or so and claiming that current P/E ratios are below average and stocks are "cheap" fails to incorporate the generally lower enthusiasm that comes with a secular bear market trend.
Liquidity - remember when investors worried about the end of the Federal Reserve's QE2 Treasury Bond buying program? The liquidity injected into markets from low interest rates was presumed to add fuel to all manner of asset prices. Stocks have staged major rallies after both instances of Fed bond-buying. The most recent instance being the August 2010 - June 2011 phase. With the Fed moving to a neutral posture vis-a-vis buying bonds, the expectation would be higher interest rates perhaps providing another headwind for stocks. At least through the first week without the Fed's QE2 support, stocks appear quite comfortable without the Fed's help. But volume (e.g. a form of measuring liquidity in the market) has been only average. Though bonds are not offering much in the way of interest rate returns, the overhang of worries facing investors recently has kept a true rush into stocks from happening just yet.