The rally continues but may be in need of a pause to refresh

Market observations for the week of Oct. 11 to Oct. 15, 2010

Claymore Investments, Inc. 19 October, 2010 | 9:55PM
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The major market indices finished the week modestly higher as expectations of further easing by the Federal Reserve (the "Fed") in the United States and a solid start to third quarter earnings season kept a bid under stock prices.

The Dow Jones Industrial Average added 0.51%, the Wilshire 5000 Total Market Index rose 0.99%, the S&P 500 Index gained 0.95% and the NASDAQ Composite Index tacked on 2.78%. Sector breadth was positive as eight of the 10 S&P sector groups finished higher in the U.S. The technology sector (3.91%) was the best performing while the financials sector (-2.38%) was the laggard. The Canadian market, as measured by the S&P/TSX Composite Index, gained 1.31%.

Quantitative easing all but a done deal

Tepid economic data and further confirmation from Fed Chairman Ben Bernanke all but sealed the deal for another round of quantitative easing (QE) at the upcoming November Federal Open Market Committee (FOMC) meeting.

On Friday, speaking at the Boston Fed Conference, Dr. Bernanke stated that "additional monetary stimulus may be warranted because inflation is too low and unemployment is too high." While his speech contained little in the way of new information, it did hint strongly that more easing is likely on the way. Dr. Bernanke's speech followed the release of the Sept. 21 FOMC meeting minutes on Tuesday that also suggested that policymakers were generally in agreement that further stimulus was needed to jumpstart the economy.

The markets have essentially deemed a second round of quantitative easing as a done deal. The consensus viewpoint seems to be centered on a program of approximately $500 billion in size that will entail buying U.S. Treasury notes over a period of several months. The Fed is also expected to include some kind of verbiage that would give it leeway to modify the program as needed. This would allow it to take into account the incoming economic data and would give it the flexibility to extend the program if needed.

While it's debatable whether additional QE will help resuscitate the economy, the Fed seems to have painted itself into a corner, and not doing anything no longer appears to be an option. The question then becomes how much of this has already been discounted in the markets.

Fed Chairman Bernanke first raised the issue of additional easing in his Aug. 27 speech at the Fed meeting in Jackson Hole, Wyo. Since then, the S&P 500 has gained over 10%, the yield on the 10-year Treasuries has declined to a recent low of 2.38% (yield and price move in opposite directions) and the U.S Dollar Index has lost 7%.

On the latter point, while interest rates represent the "cost" of money, they also represent the "return" on money. One of the primary goals of quantitative easing is to push bond yields lower and therefore lower the cost of borrowing. The other side of the coin is that the return on money becomes less competitive and therefore results in investors selling dollars in search of higher-yielding currencies and investments. The downward pressure on the dollar will likely remain in place as long as the Fed maintains its easy money bias.

Dollar devaluation = asset price inflation

A lower dollar helps the Fed in a number of ways. First, it makes the cost of imports more expensive while making dollar-denominated commodities, like oil, cheaper for foreign investors. This should result in a bias toward higher prices (i.e. inflation).

In addition, exports should benefit 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.

As a side note, there are still two full weeks to go before the Fed's next FOMC meeting and plenty of economic reports between now and then. While I doubt any of the releases will be strong enough to derail further quantitative easing, signs of modest strength in the numbers could lessen the degree of aggressiveness that the Fed ultimately employs.

While additional quantitative easing is not expected to be a silver bullet that will magically save the economy, it should help keep borrowing costs low and boost confidence among both consumers and businesses. Corporations are currently sitting on a cash hoard of approximately $2 trillion as they've been reluctant to spend not only because of economic uncertainty but regulatory and political instability as well. In committing to more quantitative easing, the Fed is telegraphing that it intends to provide a downside buffer to the economy. In other words the Fed is saying, "We've got your back." In addition, the upcoming midterm elections should provide a further boost to clarity on the political front. A congressional victory by the Republicans would likely remove some of the regulatory and taxation uncertainties.

Economic data

As has been the case over the past few weeks, the recent round of economic data showed signs of stabilization but lacked vigour. Certainly none of the data released last week was strong enough to dissuade the Fed's thinking in terms of additional quantitative easing. In fact, the core consumer price index is now trending at an annualized rate of 0.8%, the lowest level since early 1961. This latest data underscores the Fed's concerns of inflation being uncomfortably low. On a mildly positive note, the Commerce Department reported on Friday that retail sales during the month of September rose a better than the expected 0.6%, while the August data was revised higher.

Q3 earnings summary

As of Friday, 47 members of the S&P 500 have reported quarterly results, with overall earnings up 33.5% on a year-over-year basis. More than 71% of the companies have beaten analyst expectations while 19% have fallen short. The "beat" rate is significantly better than the historical 61% average. Revenues are up 7.7% in the quarter, so far. Overall quarterly results are being fuelled by the technology, industrial and consumer discretionary sectors. When all is said and done, third-quarter earnings for the S&P 500, according to Bloomberg data, are expected to rise 23.8%. If that growth rate is achieved, that would mark the third consecutive quarter of 20%-plus growth.

A pause to refresh needed?

Last week the number of stocks in the S&P 500 that were trading above their 50-day moving average reached 91%. While this is a sign of a healthy advance--as it shows there is broad participation--it is also an area that has generally coincided with an overbought market and has typically foreshadowed a period of consolidation. In addition, as often pointed out in these missives, sentiment--fear and greed--is often a determining factor in making investment decisions. These emotions also tend to be contrarian in nature, meaning fear is often lowest near market peaks and almost always elevated near market troughs. Last week, the CBOE Volatility Index (aka the "fear" index), fell to its lowest level since April, potentially indicating that investors have become too complacent. Stay tuned.

Looking ahead

The earnings calendar will take centre stage this week as approximately 120 S&P 500 companies are scheduled to report. The economic calendar will also be in focus with reports on housing, industrial production, and regional manufacturing. Also of interest will be the release of the Beige Book report on Wednesday. Fed leaders will be out and about this week with over 15 speeches by various Federal Reserve members on the docket. Investors are expected to listen closely to these speeches in an effort to glean further details on expected quantitative easing programs.

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Claymore Investments, Inc.

Claymore Investments, Inc.  

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