US stocks surge to the highest levels of 2012, just 7.1% below the October 2007 record high. The S&P 500 closed earlier today at the high for 2012, up 18.0%, handily exceeding our 2012 forecast of 12% gains.

In April we wrote: "The market will do one of three things over the rest of the year: 

1. Trade flat for the next 9 months - not likely.
2. Surge into a "buying panic" as investors finally jump back into stocks, which would leave the market up 20% or more by year end.
3. Plummet as some exogenous event (like last year's Japanese tsunami or the Greek credit crisis) cause investors to retreat to cash once again." 

In June after stocks slumped over concerns about Europe, we wrote "US stocks however, were a good value a month ago and a better value today. With the weak hands forced out by the recent 10% pullback, we are moving forward with investments in stocks." With two and half months remaining in the year, our "buying panic" forecast is starting to look prescient.

A client writes "I'm curious to know how Heron is adapting to the major changes taking place and which might emerge in the short to mid-term in the markets."

Our answer: we care ever LESS about what happens day to day in the markets, which at this point is entirely random. We maintain our core discipline of buying REAL companies with REAL revenues and REAL and SUSTAINABLE earnings. We balance our primary US equity allocation with non-US stocks (primarily through index funds,) bonds, commodities and cash. We build all-weather portfolios, which cope well with anything the markets throw at us. Most importantly, we rely on our own TRAINING, EXPERIENCE and INSTINCTS and don't care a fig for the conventional wisdom, which time and again is wrong.

Good news/bad news right now

News about the European debt crisis slipped off the front pages over the last three months. The problems are still there, but without the daily dose of anxiety, investors have concentrated on buying oversold stocks; S&P 500 up 7.5%, Germany up 15.2%, France up 10.1%. Among major stock markets, only China is negative on the year and down 8.6% for the quarter as growth eases from the breakneck +8% annual growth in GDP that has prevailed for the last ten years.

As Europe's mood improves, the Euro rebounds against the dollar, which is good news for US exports. The fall in the dollar boosts the price of gold, rallying recently to $1768/oz. from $1539 this summer, and may yet take out the high of $1900 of September 2011. Commodity prices in general are on the rebound after slumping into the summer. Higher commodity prices signal inflation, but also signal an uptick in demand. Oil prices, as defined by US WTI are off the summer lows, currently in a trading range between $90-$100. Energy demand is up in the US, down in China, and supplies from the Middle East are on the increase even as traders worry about the potential for conflict with Iran.

The Case-Shiller housing indices show that housing bottomed in the first quarter of 2012, rose modestly in the second quarter. The inventory of distressed and foreclosed housing shrank, resales hit a two year high, and building permits are up. At current levels, US housing prices are below long term valuations when compared to rents and personal income. There is much pent up demand for housing. However, mortgages remain hard to come by, so we expect only modest gains in housing for several years. Still compared to the 30-40% collapse in prices between 2006-2009, relative calm lets all Americans breathe easier.

The Middle East situation remains volatile as always. The biggest question mark is how far will Iran go to pursue its nuclear weapons program before provoking an attack from Israel and/or the US.

The biggest worry we have right now is the rapid deceleration in S&P 500 revenues and earnings. We had a big rebound off the bottom of the 2009 recession, and corporations have moved aggressively to slash costs and payrolls. There are no more cost savings available to boost earnings, so future growth is dependent on revenue growth, which is hard to come by given weak demand in the US, no demand in Europe and faltering demand in emerging markets such as China.

If you're a partisan Republican, skip this section

As we have said often, it's not our job to favor one party or the other, but to figure out who the next president is likely to be and invest accordingly. In the past three weeks following the conclusion of the conventions, it seems that fence sitting voters have started coming over to the Obama camp. At this time in the election cycle, we visit www.RealClearPolitics.com daily for a virtually unlimited menu of polls, opinions and commentary.  

At the national level, Obama maintains a narrow but expanding 3% lead over Romney. However, as we learned from the 2000 election, it's not the national poll that matters but the state by state polls that factor into the Electoral College. Obama leads with 247 likely electoral votes versus 191 for Romney. 270 votes are needed to secure the election, so Obama is short by 23. Of the 8 states still in play, Obama has small but expanding leads in 7.

If Obama wins Florida, the election is over by 9PM EST. Florida is still close, but Ohio and Virginia seem to be moving decisively to the Democratic column, in which case Obama still wins. With seven weeks remaining, the only opportunity Romney has to distinguish himself is in three upcoming presidential debates. Whatever you think of Obama, he is a gifted public speaker. Romney by comparison suffers every time he opens his mouth.

We're also watching the Senate picture closely. Two weeks ago, it seemed that the Republicans would pick up 4-5 seats, which would give a 52-45 majority to Republicans. In the latest polls, the Republicans might only pick up one seat, which would leave the Democrats in the majority. It is unlikely that Democrats will take control of the House of Representatives in 2012.

Strategy

Investors hate uncertainty. Even if it seems like the outcome of the US presidential election is becoming predictable, the composition of the US Senate and House of Representatives remains in flux. The next president, Obama or Romney, will have to immediately confront another negotiation to raise the US debt ceiling and also revamp the US tax code effective January 1st. Given the long, bitter and partisan campaign, few in Washington will be willing to compromise, so that's a negative for stocks.

Of greater import, will the stabilization in housing prices allow Americans to feel confident enough to spend money? S&P 500 revenues, earnings, and ultimately US stock prices are dependent on US GDP growth stronger than 1.7%/year. We continue to invest cautiously on behalf of our clients.