With Profits Taken, Where Will Stock Prices Head in December?: Searching for Alpha for December 2010

After giving back some profits in November, traders are keen to discern the most likely direction for markets in December. The fact that many mutual funds and hedge funds are barely above water for 2010 makes this determination especially critical.

The global economy is certainly facing a number of headwinds. The European debt crisis continues, with Spanish and Portuguese bonds facing potential downgrades. The contagion is starting to affect more developed-country fixed-income markets in the region.

There is concern that a similar type of crisis could occur domestically. The municipal bond market has weakened considerably in the last four weeks, and even though yields have risen dramatically (especially on the long end of the curve), demand for new issues has waned. This would be an even greater strain on the Fed’s attempts to put the recovery on more solid ground, and could be a game changer for the equity rally that began in March 2009.

Fortunately, the media dreck surrounding the municipal market appears to be overblown.  According to Bloomberg, muni failures are trending lower, with $2.5 billion in defaults so far in 2010, versus $7.3 billion for 2009 (and $8.2 billion for 2008). Municipalities appear to be doing everything they can to pay off their debts, including laying off employees and reducing services when needed. Overall, bond interest is a small portion of a typical municipality’s budget, and facing the specter of not being able to borrow should they default, there is simply no benefit (and lots of detriment) to default.

Europe’s woes seem considerably more problematic. The crisis has put upward pressure on the dollar, which threatens to widen our export deficit. But I don’t see such issues immediately impacting the markets in the last month of 2010.