The calm before the storm?

Market observations for the week of Oct.18 to Oct. 22, 2010

Claymore Investments, Inc. 26 October, 2010 | 9:51PM

The Dow Jones Industrial Average added 0.63%, the Wilshire 5000 Total Market Index rose 0.53%, the Standard & Poor's 500 Index gained 0.59% and the NASDAQ Composite Index tacked on 0.43%. Sector breadth was positive as eight of the 10 S&P sector groups finished higher. The financials sector (1.91%) was the best performer while the materials sector (-0.63%) was the laggard. The Canadian market, as measured by the S&P/TSX Composite Index, finished little changed.

U.S. dollar takes centre stage

Last week's trading activity was dominated by the action in the currency markets. In fact, for most of the week, risk assets (stocks, commodities) traded in an almost perfectly inverse pattern to the greenback.

Over the past couple of weeks we have addressed the likelihood of additional stimulus measures by the Federal Reserve (the Fed) at the conclusion of the Nov. 3 FOMC meeting. As mentioned last week, one of the primary goals of quantitative easing (QE) is to lower (or at least cap the upside) in interest rates in an effort to spur borrowing/lending activity. However, interest rates play a dual role in the economy: on one hand they represent the "cost" of money, while on the other and more importantly in terms of the dollar, the "return" on money.

With investors generally void of specific details in terms of the anticipated quantitative easing program (how big, over what time frame, etc.) the focus shifted back to economic data and how it may ultimately sway these known unknowns. When economic data suggested a stronger economy, the dollar would rise, reflecting expectations of a less aggressive stimulus program, whereas weaker data had the opposite impact.

Complicating matters were comments last week from Treasury Secretary Timothy Geithner maintaining that the U.S. government supports a "strong dollar" policy. This caused confusion in the marketplace as the expected action by the Fed, while maybe not intentional, is ultimately a "weaker dollar" initiative. While it is not uncommon for a Treasury Secretary to jawbone about a stronger dollar, this was somewhat out of character for Mr. Geithner as he rarely ever mentions the greenback. Ultimately, we believe that Mr. Geithner was playing politics and that the U.S. will continue to allow the dollar to decline.

In the near term, dollar weakness can provide a crutch to the hobbled economy and help the Fed with price stabilization. A weak dollar makes the cost of imports more expensive and therefore provides an incentive for U.S. consumers to shift their preference toward U.S.-manufactured goods. Secondly, a weak dollar should benefit U.S. exports as U.S. goods become more competitively priced in the global marketplace. This additional demand, at least in theory, should lead to higher profits (and therefore higher stock prices) and an eventual uptick in hiring activity.

Beige Book still neutral

Last week the Federal Reserve released its Beige Book report. The report, which provides anecdotal information collected by the 12 Federal Reserve district banks, showed a modest pickup in economic activity, but generally highlighted an economy that remains stuck in neutral. Bottom line, the economy doesn't appear to be getting any worse, but the report offered little in the way of data that would likely derail the Fed from initiating a second round of QE.

Golden rules

Wall Street lexicon is littered with many long-standing adages, some of which 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. Last week, the S&P 500 achieved a "golden cross" signal, a technical pattern where the 50-day moving average moves 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.

Q3 earnings summary

Through Friday, 159 members of the S&P 500 have reported quarterly results, with overall earnings up 45.6% 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%. Of the companies that have reported, 79.1% have beaten analyst expectations while 13.9% have fallen short. The "beat" rate is significantly better than the historical 61% average. Revenues are up 8.1% (+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 25.9%. If that growth rate is achieved, that would mark the third consecutive quarter of 20%-plus growth.

Looking ahead

This will be the peak week for earnings reports as 179 members of the S&P 500 are scheduled to release results. The economic calendar will also be in focus with reports on housing (existing and new home sales), consumer confidence, durable goods orders and the preliminary reading on third-quarter GDP. Fed leaders will be very active early in the week with four speeches scheduled for Monday, including an update on housing from Fed Chairman Ben Bernanke. With a week to go before the next FOMC meeting, investors will be looking to glean any further details on expected quantitative easing program.

About Author

Claymore Investments, Inc.

Claymore Investments, Inc.