Stay the course with equity markets.

After the crash of 1987, a ‘regularity’ of stock market behaviour was popularised in the form of a negative October effect. It might even have been introduced well before then. The Wall Street crash of 1929 occurred in October and no doubt there were lesser, but still noteworthy, incidents throughout the intervening Octobers.

However, I’m not sure when I last saw a reference to the effect. Perhaps it no longer exists – or perhaps never did. I remember experimenting with regressions to test for a negative October effect and discovered, for the period investigated, that it was the crash of ’87 alone that gave rise to any statistical significance. Without it, there was no reason to think that October was especially ominous for equity markets.

And so to this October which, according to Bloomberg, ‘marks the third anniversary of the [eurozone] debt crisis’. Yet, despite the hardship, the eurozone has outlived all expectation of its demise, at least thus far, and moreover, key indices of equity market activity, notably in the US, not only reached new post-financial crisis highs last month but several indices also reached new all-time highs. Not bad!

Might the gains be given up? Equity markets enter the final quarter of the year with still some way to go before their technically overbought condition is unwound. They also enter it on the week that contains two sets of big US market moving numbers; the ISM surveys and the Nonfarm payrolls. Disappointment here could induce selling.

A number of the major central banks meet to review policy this week but there is likely to be little of interest for the markets. While the Fed is not among them, September’s FOMC Minutes are released later in the week. What could be of interest is the discussion, if any, over reservations about the merits of the additional stimulus the FOMC agreed. A few non-voting members of the FOMC have doubts about the merits of more stimulus (e.g., Fisher, Plosser). Then again, a few non-voting members think the FOMC should go further than it does with its forward guidance (e.g., Evans, Kocherlakota).

On the other hand, the markets start the quarter knowing that some of the prevailing uncertainty has been diminished. The European Central Bank is ready to respond to a request for financial assistance, as is the European Stability Mechanism. If it wishes, Spain is in a position to make that request. The conditionality is unlikely to be any more burdensome than what is already required of Spain. According to Olli Rehn, European Commissioner for Economic and Monetary Affairs and Vice-President of the European Commission, the measures put forward in last week’s budget went beyond what the European Commission had asked.

Also, the independent stress tests on Spain’s banks have been completed on the reasonably ‘testing’ assumption of a 6.5 percent drop in output between 2012 and 2014. That, by any reckoning, is a serious recession.

Nothing though is ever plain sailing. For the Spanish Prime Minister, the challenges remain with an election scheduled for the Basque region later this month and for Catalonia next month. The regional governments want greater autonomy in relation to budgetary control.

Also, in adding their ‘revisionism’ to what came out of June’s EU summit, the German, Dutch and Finnish Finance Ministers may have thrown something of a spanner into the works. Commenting on this last week, it was noted that Brussels responded by saying the communiqué issued after the EU summit still stood. Perhaps the communiqué got it wrong. Whatever the case, the issue is now to form part of the Eurogroup’s agenda at next week’s meeting and who knows what might be required to resolve it?

It’s a wonder that markets are choosing not to focus on the US fiscal cliff. As things stand Wall Street is saying it’s not going to happen and that Congress will defer the deadline for a deficit reduction programme into next year – spring, summer end of the year.

Nor is Wall Street worried about earnings. A hand full of companies in the S&P 500 report their third quarter results this week before the earnings season gets underway in earnest. The estimates are being revised down, partly in response to guidance and pre-announcements. Year-on-year earnings growth for the third quarter is now expected to come in at minus 2 percent according to Thomson Reuters, compared to plus 3 percent back in July. Wall Street should be worried knowing that further revisions are likely.

But if you look at Intrade.com, the punters rate the chances of a US recession next year as about one in four. They also rate the chance of President Obama being re-elected as over 76 percent. This is down slightly from something that was close to 80 last week but it still sounds like a landslide victory. It will be interesting to watch how the odds shift with the TV debates, which start this Wednesday and finishes on the 22 October.

There is more than enough here, even without bringing in China, to get a reaction out of technically overbought markets but there has been little response. Do you wait for it or look ahead? If the odds of a US recession are one in four you look ahead. We see them as no more than this – if that. Despite the obstacles, eurozone policy is forward looking. Also, as we said before, neither the ECB nor the Fed is for turning. The ECB is determined to eliminate the tail risk of euro disintegration and the Fed is determined, as long as Bernanke is Chairman, to get more jobs out of the US economy. So you stay the course with equity markets.

Important Notes

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