The danger of chasing the market

The rally in markets this year is something of a surprise.

At the end of last year you had to hunt hard for the bulls. Yields on 10-year Spanish and Italian debt were hovering around the 7% crisis level, Greece was rapidly heading for default, the global economy flirted with recession and China was tipped to crash at some point in 2012.

With headwinds such as these it was little wonder everyone was so bearish.

Morgan Stanley is among those which have been caught out by the rally and admits the probability of its bear case scenario has weakened, especially in the near term.

So what has changed?

Morgan Stanley highlights three key factors behind the turnaround in fortunes: 1) an improvement in global leading indicators, 2) progress in Europe with the announcement of a ‘fiscal compact’ at the EU summit followed by ECB rate cuts and the introduction of the LTRO (long-term re-financing operations) program and 3) the renewed extension of tax breaks in the US, which is likely to delay meaningful fiscal tightening for another year.

This has triggered the second biggest decline in 15 years in the 3-month put-call ratio, while the one-month performance of cyclicals over defensives is close to record highs.

This is reflected in markets with the FTSE 100 hitting its highest level in six months last night, while the S&P 500 is trading around a five-month high.  

However, while Morgan Stanley is surprised by the positive news, it has not completely thrown its bear case out of the window.

The bank's European equity research team said: 'While the equity rally that this news flow has generated increases our level of discomfort in the short term, it does not necessarily imply that our base case assumptions for this year will prove incorrect...the market may well rise further in the short term, but we continue to believe that a volatile and uncertain macro environment will weigh on stocks as we move through the year.'