European Uncertainty Raises “Coat Tail” Risk

Week in Review: 11/14/11 – 11/18/11

The major market indices finished the week lower as the woes in Europe are raising contagion fears and concerns of “coat tail” risk.

Performance for Week Ending 11/18/11:

The Dow Jones Industrial Average (Dow) lost 2.94%, the Wilshire 5000 Total Market Index^SM (Wilshire 5000^SM) fell by 0.19%, the Standard & Poor’s 500 Index (S&P 500) declined 3.81% and the Nasdaq Composite Index (Nasdaq) shed 3.97%. Sector breadth was negative as all 10 of the S&P sector groups finished lower. The Financials sector (-5.57%) was the worst performer followed by Materials (-5.56%) and Energy (-5.38%). The Canadian market, as measured by the S&P/TSX Composite Index, lost 3.13%.

*See Bottom of the Page for Index Definitions

MARKET OBSERVATIONS: 11/14/11- 11/18/11

The major market indices finished the week broadly lower reflecting concerns about the U.S. banking systems exposure to the European crisis, fears that debt contagion in Europe is starting to spread, worries that rising energy prices could become a headwind to the U.S. economy, and signs the deficit “super committee” negotiations may have hit a brick wall. Technical considerations were also at work as the S&P 500 violated two key support levels. 

Global markets remain highly correlated and despite signs the U.S. economy has been gaining traction, the likelihood of a U.S. decoupling in the near term seems unlikely, in my opinion. With that said, it is always darkest when your eyes are closed. While getting investors to jump back into the markets in the near term may be like trying to push water with a fork, we must also be cognizant that valuations, monetary policy, corporate balance sheets, and seasonal factors are all very favorable and potentially set the stage for a rebound in the equity markets. 

Europe Continues to Steal the Show
The problems in Europe continue to plague the markets as European policymakers seem to be fighting a forest fire with an eye-dropper. The threat of contagion continues to build as evidenced by the recent rise in borrowing costs for countries like Spain and Italy. Even Triple-A rated countries like France, Austria and the Netherlands have not been immune from rising bond yields. The growing uncertainty reflects the baby step approach by policymakers while market forces are clamoring for a big bazooka-like solution. While the appointment of new government officials in both Greece and Italy is a step in the right direction, execution risk still remains high. In addition, while Prime Ministers Monti and Papademos are both considered excellent financiers, how they will operate within a political environment remains unknown. 

U.S. Economy—More Green Shoots
The recent batch of economic data continues to show that the U.S. economy is gaining traction and has led to many forecasters raising their economic growth assumptions for the fourth quarter. Last week, the Commerce Department reported that Retail Sales rose at a better than expected rate, while housing continued to shows signs of stabilization—albeit at very depressed levels. Employment statistics remain encouraging as weekly jobless claims continue to trend lower. In addition, the employment component of the Philadelphia Fed Index, which has a strong correlation to the monthly nonfarm payrolls, rose sharply suggesting a strong showing for the November payroll report (reported on Dec. 2). On Friday, The Conference Board's index of U.S. leading economic indicators rose 0.9% on a month over month basis, the strongest showing since last February. The index has now risen for six consecutive months, suggesting that the economy will continue to gain momentum into the fourth quarter and the risk of recession has receded. 

Will Rise in “Black Gold” weigh on Black Friday?
Oil prices briefly breached the $100/barrel level last week, raising concerns that rising energy costs could become a headwind to consumer spending and in turn, weigh on the overall U.S. economy. Oil prices have gained approximately 30% since the trough reached in early October and stand at the highest levels since mid-summer. The gains are a reflection building momentum in the U.S. economy, geopolitical tensions in Iran, and technical factors resulting from an effort to ease a bottleneck at the Cushing, Oklahoma storage hub that has caused the price of U.S. oil (WTI) to trade at an unusually large discount to imports (Brent). 

Gasoline prices still remain well off their peak levels reached in early-May, but are almost 50-cents higher than they were one year ago. While the recent trend in gas prices has been lower, the historical relationship between oil and gasoline prices would suggest that higher gasoline prices are likely in the coming weeks. An uptick in gasoline costs could pose a significant risk to consumer spending, which accounts for almost two-thirds of U.S. economic growth. Although consumers have become accustomed to elevated fuel costs, the closer we get to the psychological $4/gallon level (gas prices have averaged $3.43/gallon over the past 30 days) the more likely they could become a headwind to consumer spending. 

The day after the upcoming Thanksgiving holiday, dubbed “Black Friday” will be watched very closely to see how wide consumers open their wallets. A solid “Black Friday” followed by a strong “Cyber Monday” will likely be a “tell” about the progress towards a consumer-driven recovery. Good news from retailers could act as a catalyst for hesitant investors to reenter the markets. According to the National Retail Federation, the average consumer is expected to spend $704.18 on holiday gifts this season, a 2% downtick from last year. 

Super Committee Deadline
On Wednesday (11/23) the focus will shift from Europe to Washington as the so called deficit super committee is due to deliver a proposal to address the country’s fiscal mess. If a decision by the bipartisan panel is not reach, $1.2 trillion of cuts will automatically kick in on January 1, 2013. The committee was formed in August as part of the compromise to raise the debt ceiling and was tasked with reducing the budget deficit by at least $1.2 trillion. There has been much posturing and finger pointing in the media from both sides of the aisle, however, the general consensus is that no credible plan will be reached and therefore the automatic cuts will be triggered. 

Besides creating additional ill will towards politicians, the lack of any decision will have little near-term impact. The $1.2 trillion of automatic cuts is structured to be deployed over a 10-year time frame, with most of the major cuts coming in the latter years. This may explain the lackadaisical attitude in Washington towards reaching a deal as policymakers know they will have additional time to potentially reach a compromise in the coming months. Since 2012 is an election year, both parties will have an incentive to strike a deal as I’m sure they are looking forward to using this potential “success story” as part of their campaign rhetoric. 

Looking Ahead
As mentioned earlier, the focal point for the week will be the super committee meeting on Wednesday. Despite being a holiday-shortened week, the economic calendar will be front-end loaded with reports due out on existing home sales, regional manufacturing (Chicago, Richmond), the Q3 GDP, Durable Goods Orders, Consumer Confidence, and Initial Jobless Claims. The earnings calendar continues to wind down with only eight members of the S&P 500 scheduled to report results. Also of note will be Tuesday’s release of the FOMC meeting minutes from the November 1 and 2 gathering.

MARKET VIEWPOINT

I continue to believe that the U.S. equity markets remain well positioned for positive performance over the next several quarters, especially relative to Europe and the emerging markets. The upbeat viewpoint reflects the markets attractive valuation, the overall healthy nature of corporate balance sheets, expectations that corporate profits will remain strong, and the pledge from the Federal Reserve that monetary policy will remain accommodative for at least the next two years. In light of the favorable macro environment, I continue to believe that market weakness represents an attractive entry point, especially for longer-term investors. 

Potential Risks/Wildcards: Expectations that equity prices will trend higher over time assumes that the global economic recovery continues to progress, that monetary policy remains accommodative and that no major fiscal policy mistakes are made. A rapid rise in global inflation resulting from a sustained rise in energy and commodity prices would pose a substantial risk, especially in the emerging markets. Any of the above factors would likely lead to a reevaluation of the bullish outlook.

Definitions

The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally defined as the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928. 

Wilshire 5000 Total Market Index^SM represents the broadest index for the U.S. equity market, measuring the performance of all U.S. equity securities with readily available price data. The index is comprised of virtually every stock that: the firm’s headquarters are based in the U.S.; the stock is actively traded on a U.S. exchange; the stock has widely available pricing information (this disqualifies bulletin board, or over-the-counter stocks). The index is market cap weighted, meaning that the firms with the highest market value account for a larger portion of the index. 

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. 

The Nasdaq Composite Index is a broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market. The index was developed with a base level of 100 as of February 5, 1971. 

The S&P/TSX Composite Index is a capitalization-weighted index designed to measure market activity of stocks listed on the Toronto Stock Exchange (TSX). The index was developed with a base level of 1000 as of 1975. 

The Philadelphia Federal Index is a regional federal-reserve-bank index measuring changes in business growth. The index is constructed from a survey of participants who voluntarily answer questions regarding the direction of change in their overall business activities. The survey is a measure of regional manufacturing growth. When the index is above 0 it indicates factory-sector growth, and when below 0 indicates contraction. 

The Conference Board Leading Economic Index (LEI) is made up of index of supplier deliveries (vendor performance), interest rate spread, stock prices, real money supply, index of consumer expectations, building permits, and manufacturers' new orders for nondefense capital goods, average weekly manufacturing hours, average weekly initial claims for unemployment insurance (inverted), and manufacturers' new orders for consumer goods and materials. 

The Conference Board is a not-for-profit organization that creates and communicates knowledge about management and the marketplace to help businesses strengthen their performance and better serve society. The Conference Board operates as a global independent membership organization working in the public interest. It publishes information and analysis, makes economics-based forecasts and assesses trends, and facilitates learning by creating dynamic communities of interest that bring together senior executives from around the world.

Indices do not include any expenses, fees, or sales charges, which would lower performance. Indices are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

The individual companies mentioned in this piece were for informational purposes only and should not be viewed as recommendations.

The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes. This document contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Information in this report does not pertain to any investment product and is not a solicitation for any product. This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy.