Big week; a big reaction?

Market observations for the week of Oct.25 to Oct. 29, 2010

Claymore Investments, Inc. 2 November, 2010 | 9:44PM

The major market indices finished the week little changed as investors appeared indecisive ahead of this week's barrage of market-moving events. Stocks have been trending sideways for the past couple of weeks as the markets appear to be caught in a period of price discovery while investors try to gauge what is currently discounted in the market and what is likely to come to fruition. The upcoming week is arguably one of the most important weeks of the year and the reaction to this week's events could set the tone of trading for the remainder of the year.

Known unknowns

While Republicans are expected to make significant headway in Tuesday's midterm elections in the United States, and the Federal Open Market Committee (FOMC) is likely to embark on another round of quantitative easing (QE) on Wednesday, there still appears to be many known unknowns. For instance, with a strong likelihood that the Republicans capture at least the House, the question becomes will this gridlock scenario lead to a lame duck environment (i.e. nothing gets done) or will a period of compromise develop? To get things like the Bush tax cuts extended, obviously compromise will be needed and the question then becomes whether disgruntled politicians have the intestinal fortitude to swallow their pride? The answer will likely depend on the final vote tally and the makeup of the new Congress.

FOMC meeting

While additional quantitative easing seems to be a done deal, the markets still appear to be struggling with the scope of the program, and whether another giant infusion of liquidity into the market will boost economic growth. Listed below are some "back-of-the-envelope" thoughts on potential outcomes and reactions. Scenario number two (base-case) seems the most likely outcome. However, with some Federal Reserve members showing resistance and others expressing a strong need for more stimulus, this outcome is not a sure thing.

Blow-out program: The Fed announces an initial program well in excess of US$500 million and promises to keep its foot on the gas pedal as long as it takes. The market reaction is surprise. This scenario would likely lead to a rally in both the equity and fixed income markets; however, some may read the more aggressive action as a sign that the underlying economy is still on life support. If so, this would likely cap the upside and future performance would become data dependent.

Goldilocks (base-case scenario): Initial program of US$500 billion dollars spread over several months. The Fed statement is likely to include verbiage that gives it flexibility to adjust the program as needed. Ultimately the program could expand to US$1 - $1.5 trillion. The market reaction is a sigh of relief. Markets would likely see a knee-jerk "sell the news" decline; however, weakness would likely be short lived as the focus returns to macro fundamentals and the expected positive impact of QE efforts.

Negative Surprise: Anything shy of the Goldilocks scenario. The market reaction is mixed. This adverse scenario is not likely baked into the cake, so the initial reaction would likely be an across-the-board sell-off in both the bond and stock markets. Interestingly, the performance from there could diverge. Bonds would likely find buyers as yields back up and fears over a double-dip recession resurface. Stocks would likely give back the bulk of the gains from the late-August rally and then "chop" sideways until clarity on the Bush tax cuts emerges and economic data improves.

Regardless of the outcome, none of these situations are likely dire enough to return the markets to bear market status, as some iteration of all of these scenarios are in one way or another reflected in the market. While that's not to say there couldn't be a period of consolidation to adjust for the news, ultimately the upward trend is likely to be maintained.

While the current state of the recovery is clearly disappointing, it doesn't necessarily mean that the equity markets can't continue to move forward. The flagging recovery will likely mean that the Fed will keep its foot on the gas pedal (or at least off the brakes) for the foreseeable future. In addition, while the economy's growth is subpar, it is still growing. We also have to remember, as pointed out in these missives numerous times, the S&P 500 derives nearly half of its revenues from outside the United States. While the U.S. economy appears to remain marred in mediocrity, other economies around the globe appear to be in much better shape.

Index Closing Price
10/29/2010
Week Ending
10/29/2010
Year to date
through
10/29/2010
Dow Jones Industrial Average 11118.49 -0.13% 6.62%
Wilshire 5000 Total Market 12259.80 0.12% 7.34%
S&P 500 1183.26 0.02% 6.11%
NASDAQ Composite 2507.41 1.13% 10.50%
S&P/TSX Composite 12676.24 0.60% 7.92%

Economy remains stuck in neutral

Last week the Commerce Department reported that the economy expanded by a paltry 2.0% in the third quarter. While the report was on target with economists' expectations, it underscored that the economic recovery continues to spin its wheels. This scenario was also evident in last week's housing data which show stabilization, but at very depressed levels. Initial jobless claims fell to the lowest level since July but still remain at levels that will do little to lower the overall rate of unemployment. This latest round of data likely solidified the need for more stimulus, while at the same time creating a negative tone for incumbent politicians going into Tuesday's elections.

October performance

October marked a second straight month of gains with the major indices advancing by over 3% in aggregate. The gains over the past two months have been fuelled by the prospects for another round of stimulus from the Federal Reserve, stabilization in economic data, strong third quarter earnings, and the anticipated investment-friendly outcome to the midterm elections. Collectively, since the end of August the Dow has added 12.8%, the S&P 500 has gained 11% and the NASDAQ has tacked on 18.6%. From a sector point of view technology has led the way (+19.3%), followed by consumer discretionary (+16.9%) and energy (+15.2%). The leading sectors are all levered to the underlying health of the economy and their outperformance likely signals investor expectations of better times ahead.

Q3 earnings summary

Through Friday, 337 members of the S&P 500 have reported quarterly results, with overall earnings up 37.8% 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 28.3%. Of the companies that have reported, 75.2% have beaten analyst expectations while 17.3% have fallen short. The "beat" rate is significantly better than the historical 61% average. Revenues are up 9.6% (11.0% 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 27.5%. If that growth rate is achieved, that would mark the fourth consecutive quarter of 20%-plus growth.

Golden rules revisited

Wall Street lexicon is littered with many long standing adages. Some of my favourites and ones I consider "Golden Rules" are very relevant in today's environment, to wit:

The trend is your friend: Trends tend to be powerful motivators, as most investors are apt to succumb to follow the herd. Recently, the S&P 500 achieved a "golden cross" signal, a technical pattern where the 50-day moving average moved above the 200-day moving average. This pattern has generally been viewed as a confirmation of an upward trending market and may be seen as an additional catalyst to get the fence sitters back into the market;

Don't fight the Fed: The Fed has cut interest rates to zero and is likely to keep policy very loose for the foreseeable future. Low rates encourage flow into risk assets and discourage holding low-yielding (cash) vehicles;

Price matters (i.e. valuation): "Where you stand on the market is a function of where it sits." With the S&P 500 selling at only 12.4 times forward earnings, valuation is compelling. In fact, based on work from Ned Davis Research, buying the S&P 500 at a similar multiple has resulted in an average annualized gain of almost 8% over the following decade.

While the above factors are more guide than guarantee, they generally set a favourable tone for additional upside in the equity markets. These factors coupled with favourable seasonal trends and the likelihood of a stock-friendly outcome to the midterm elections, at a minimum, should generally keep a floor under stock prices.

Looking ahead

The focal points in the week ahead will be three major events with Wednesday likely to be a pivotal day. Although midterm elections are scheduled for Tuesday, the outcome of most races will not be known until well after the closing bell. This will push the reaction to the news into Wednesday morning. Wednesday afternoon (2:15 ET) the FOMC is expected to announce the details on the QE program. On Friday, the always important employment situation report will be released. Expectations, according to Bloomberg, are for the unemployment rate to hold steady at 9.6%. Nonfarm payrolls are forecast to rise by 60K while private payrolls are expected to show a gain of 80K. Although the earnings calendar will be pushed to the backburner, approximately 100 members of the S&P 500 are scheduled to release results during the week.

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Claymore Investments, Inc.

Claymore Investments, Inc.