Investors’ appetite for risk just keeps getting stronger. Unfortunately, that’s not necessarily a good thing. And while this trend may continue through the upcoming holiday season, the risk of a major setback remains quite high.

 

The economic and survey data continue to point to a less-than-rosy outlook. Yesterday investors cheered the October retail sales headline, which was up 1.4 percent for the month. But the breakdown numbers were far less encouraging. Autos and auto parts were the big contributor in the latest period, something we don’t foresee happening going forward. Manufacturers have since scaled back production (as seen in this morning’s Industrial Production reading for October) as the government’s Cash for Clunkers program merely just robbed future months’ sales rather than kicking off a bull market for car sales.

 

Excluding autos and auto parts, retail sales fell short of expectations in the month, rising just 0.2 percent vs. a consensus view of a 0.4 percent rise. You may recall that we had a similarly misleading top-line retail sales number last month as a result of rising gasoline prices. But it’s ludicrous to argue that consumers spending more to fill up their tank is a good thing for the economy.

 

Another less-than-encouraging data point out lately is the Reuters/University of Michigan Survey of Consumer Sentiment, which declined sharply to 66 in October after rising above 70 in September. That’s far below what we would expect coming out of recession and it suggests that it’s premature to celebrate the return of the consumer to pull the economy out of the doldrums.

 

Government Stimulus 2.0 is cropping up here and there, such as extending jobless benefits (to a much as 99 weeks), the renewed tax credit for first-time home buyers, but much more spending is likely coming down the pike. The pathetic state of our economy can be seen in the 17.5 percent of the workforce either on the street or only working part time because full-time work isn’t available and in the 35 million Americans now subsisting on food stamps.

 

Stocks have notched one new high after another in recent months, but with valuations as steep as they are, at some point the piper will have to be paid. Much of these gains have occurred not because of good visibility down the road on the earnings front, but because of the so-called “carry trade.” Foreign investors have borrowed dollars at interest rates that are essentially non-existent and reinvested those funds in potentially higher returning assets, including equities.

 

As long as interest rates remain at these levels, and provided the dollar doesn’t rally the carry trade is a pretty good one. Unfortunately, as was the case in Japan (the last big carry trade), when the trade sours it can occur in a hurry with disastrous results. There’s growing chatter among nations about supporting the dollar. Moreover, given how oversold it is at this time, it won’t take much effort to bring about a decent-sized rally in the buck.

 

One investment we do like (but which is also overextended) is gold. The metal is a safe-haven investment for any kind of uncertainty, be it inflation or deflation. Like stocks, it, too, has been moving higher on the dollar’s weakness. But in the case of gold, the long-term argument for owning it here is quite strong here.