The ducks may be falling into line for a year-end rally

Market observations for the week of Nov. 1 to Nov. 5, 2010

Claymore Investments, Inc. 10 November, 2010 | 12:50AM

The major market indices finished the week broadly higher as the heavily anticipated data trifecta -- midterm elections, Federal Open Market Committee (FOMC) meeting and employment report -- contained no surprises and all three outcomes were perceived as investor friendly. Last week's strength left the major indices at or just off their highest levels in over 12 months.

The perfect storm of good news appeared to be a catalyst to get hesitant investors off the sidelines as a major veil of uncertainty was removed. With that said, the U.S. market, as measured by the S&P 500, has advanced by over 16% since the end of August and may need a pause to refresh.

The melt-up over the past several weeks has left the markets in an overbought position, from a technical point of view. This, coupled with the rising level of bullish sentiment and the high levels of investor complacency (as signal by the recent drop in the VIX Index), may be setting the stage for a near-term period of consolidation.

While any pullback in the market would be viewed as both healthy and constructive, we also believe it would be short lived and likely set the stage for a rally into year-end. Since January we have maintained a year-end price objective of 1250 for the S&P 500 and continue to feel that level is still very achievable from current levels.

While a "cooling off" period could occur, the macro fundamentals of attractive valuation, easy monetary policy, solid earnings growth, low inflation and economic stabilization should limit the downside risk. Anecdotally many large investors remain underweight equities and performance anxiety may be starting to force their hand back into the equity markets. From a technical point of view, the S&P 500 has good underlying support at the 1150 level.

Index Closing Price
11/05/2010
Week Ending
11/05/2010
Year to date
through
10/29/2010
Dow Jones Industrial Average 11444.08 2.93% 9.74%
Wilshire 5000 Total Market 12713.12 3.70% 11.31%
S&P 500 1225.85 3.60% 9.93%
NASDAQ Composite 2578.98 2.85% 13.65%
S&P/TSX Composite 12925.11 1.96% 10.04%

Midterm elections: A power shift

As expected the midterm election in the United States resulted in a power shift for the upcoming 112th Congress. Republicans were able to capture the House of Representatives while narrowing the majority in the Senate. While the playing field has been levelled and the likelihood of political gridlock has become real, the question still remains whether politicians can get past the politics and make some legislative strides.

While some behind-the-scenes "horse trading" is to be expected, we shall only worry about the sausage and not how it's made. The most pressing issue remains the pending expiration of the Bush tax cuts. If disgruntled politicians don't have the fortitude to swallow their pride and work as a team, the tax cuts will expire and the American public will be in for a massive tax increase come Jan. 1.

While the proof will be in the pudding, it is somewhat encouraging that President Obama appeared to extend an olive branch on Thursday when he indicated that he would be willing to compromise on the extension of ALL the Bush tax cuts for one to two years. This means that not only will current tax brackets for all earners remain intact, but the currently rates on both dividends and capital gains will remain unchanged as well. Mr. Obama also appeared to take on a more business friendly tone by acknowledging the importance of the business sector in jumpstarting hiring.

While we find it hard to believe that Mr. Obama will ultimately tack rightward toward the ideological center, the early signs are encouraging and likely reflect a realization that his political future may be at stake unless some changes are made.

FOMC meeting

On Wednesday, as widely expected the FOMC meeting ended with the announcement of a new round of quantitative easing (QE). Historically, when the Federal Reserve is looking to spark economic growth, its main policy lever would be to reduce interest rates. However, with the target federal funds rate hovering near zero since December 2008, the Fed has been forced to utilize nonconventional methods of stimulus. In that light, on Wednesday the Fed committed to buying $600 billion of Treasury notes over the next eight months (approximately $75 billion per month) in an effort to lower (or at least cap) interest rates. The Fed's buying activity will be concentrated in instruments with a maturity of 10 years or less (average between five and six years) as this area of the yield curve tends to be linked to and/or acts as the basis for most consumer-related lending rates (mortgages, car loans, etc.). The hope is that lower rates will spark borrowing and/or lead to a wave of mortgage refinancing.

The Fed also left its announcement open-ended, which leaves the door open for additional stimulus, if needed. To wit, as noted in the Fed statement "The Committee…will adjust the program as needed to best foster maximum employment and price stability."

It has also been argued in the media that the Fed's QE program is a blatant attempt to push asset prices higher. If that's the case, so be it. Since Chairman Ben Bernanke first hinted at additional stimulus at the Kansas City Fed meeting in Jackson Hole, Wyo., the capitalization of the U.S. stock market has expanded by approximately $1.9 trillion. While the headwinds of unemployment and weak housing are still front and center, the surge in financial assets could result in the so-called "wealth effect." This phenomenon occurs when consumers feel wealthier as a result of rising values in their investment portfolios, retirement plans, etc. The wealth effect could prompt consumers to start opening their wallets again and would mark an important next step in the road to recovery. The recent rebound in the markets could also set the stage for solid holiday sales as strength in the markets tend to correlate well with stronger holiday spending.

Employment report

On Friday, the Labor Department reported that nonfarm payrolls during the month of October rose by a much stronger than expected 151K. The results were the biggest advance since April and were well ahead of the 60K gain expected by economists. Private payrolls, which filter out the distortion associated with government hiring and firing, rose 159K. In addition, September private payrolls were revised upward to 107K versus the original forecast of a 64K gain. The unemployment rate remained unchanged at 9.6%. Other encouraging elements of the report included upticks in both hours worked and hourly earnings, as well as a 35K increase in temporary employment.

Economic data

Economic reports last week showed signs the economic recovery may be gaining traction. Last week the Institute for Supply Management (ISM) reported that its manufacturing index climbed to 56.9 in October. The data was the highest level in five months and much better than the 54.0 expected by economists (note: the ISM data is a diffusion index where readings above 50 signal expansion and below 50 contraction). The manufacturing data from the ISM was followed by its non-manufacturing (services) index which showed expansion for a 10th consecutive month. This report is encouraging as service-oriented businesses account for approximately 90% of the U.S. economy. Also of note was the 2.1% rise in U.S. factory orders in September as well as October domestic vehicle sales rising to their highest level in well over a year.

Q3 earnings summary

Through Friday, 436 members of the S&P 500 have reported quarterly results, with overall earnings up 32.4% on a year-over-year basis. Excluding earnings from the financials sector -- which continues to benefit from easy year-over-year comparisons -- earnings are still up a solid 25.9%. Of the companies that have reported, 72.6% have beaten analyst expectations while 19.3% have fallen short. The beat rate is significantly better than the historical 61% average. Revenues are up 9.0% (10.8% when excluding financials) so far in the quarter. When all is said and done, third-quarter earnings for the S&P 500, according to Bloomberg data, are expected to rise 29.6%. If that growth rate is achieved, that would mark the fourth consecutive quarter of 20%-plus growth.

Looking ahead

Both the economic and earnings calendar are relatively light this week. Economic reports of note include initial jobless claims, the Trade Balance, and University of Michigan confidence report. The earnings calendar continues to wind down with only 21 members of the S&P 500 scheduled to release results during the week. The bond market will be closed on Thursday in observance of the Veterans Day holiday.

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Claymore Investments, Inc.

Claymore Investments, Inc.