European Worries Trump Favorable U.S. Economic Data

Week in Review: 12/12/11 – 12/16/11

The major market indices finished the week lower as European debt concerns outweighed signs the U.S. economy is gaining traction.

Performance for Week Ending 12/6/11:

The Dow Jones Industrial Average (Dow) lost 2.61%, the Wilshire 5000 Total Market Index^SM (Wilshire 5000^SM) fell 2.85%, the Standard & Poor’s 500 Index (S&P 500) declined by 2.83% and the Nasdaq Composite Index (Nasdaq) shed 3.46%. Sector breadth was negative as all 10 of the S&P sector groups finished lower. The Energy sector (-4.88%) was the worst performer followed by Technology (-4.14%) and Financials (-3.82%). The Canadian market, as measured by the S&P/TSX Composite Index, lost 3.32%.

*See Bottom of the Page for Index Definitions

MARKET OBSERVATIONS: 12/12/11- 12/16/11

The major market indices finished the week moderately lower despite signs the U.S. economy is on firmer footing. As has been the case over the past several months, political theater in Europe has almost been the sole determinate of the market’s direction, while favorable economic and earnings news in the U.S. has been viewed as a mere side show.

After reaching what appeared to be a step towards fiscal cooperation at the December 9 meeting between European policymakers in Brussels, the market last week began to acknowledge the potential for implementation risk as well as the notion that pushing the fiscal pact through the parliamentary process could take up to six months. While the agreement, in my opinion, is a step in the right direction, it is however, not a panacea for what ails Europe. The lackadaisical approach that EU policymakers have taken in trying to piece together a solution to address the fiscal crisis has almost certainly left the euro zone economy in a recession. The question now becomes, will the recession be short and shallow (one to two quarters) or will it be much deeper. Ultimately the answer will be determined by policymakers’ next move and whether they have the fortitude to make some hard decisions. While the European Central Bank (ECB) has started to ease monetary policy, it is becoming increasingly clear that the ultimate remedy will be a path towards a fiscal union, the introduction of euro bonds, and the ECB becoming the lender of last resort.

The fact that the fate of Europe is in the hands of a group of politicians is scary in and of itself, however, I am of the belief that policy makers will ultimately do the right thing, as it has become increasingly clear that letting the euro zone fail and/or prolonging the necessary medication to remedy the situation, is in nobody’s best interest.

The expected economic slowing in Europe and the likely knock-on effect in the emerging markets continues to leave the U.S. markets in the best position to attract investment flows, in my opinion. In addition, as we get ready to turn the page on the calendar, the one certainty that we can count on is that volatility and uncertainty will be ever present. In times of uncertainty investors are likely to gravitate towards what are perceived to be safe haven environments. This, in my opinion, will continue to make the United States the destination of choice. Not only does the U.S. offer an expanding economy and an accommodative Federal Reserve, but market valuation is very attractive and corporate balance sheets are in very healthy shape.

As we get closer to the holidays and year-end, market volume and liquidity are likely to dry up. While many strategists are forecasting a trading range environment over the next two weeks, I think there is an equally good chance for a year-end “Santa Claus” rally. Anecdotally, many professional investment managers are underperforming their benchmarks this year and may decide to use the markets lack of liquidity to their advantage. As mentioned in these missives many times, the second worst thing for a portfolio manager, besides losing money, is underperforming their benchmark. In other words, it still may be premature to put Santa’s face on the side of a milk carton—stay tuned.

Economy
The recent batch of economic data continued to underscore that the U.S. economy is gaining traction. The data also argues that there is a growing disconnect between the economic situation in the United States and Europe. While I remain skeptical that the U.S. markets can completely decouple themselves from the political theater in Europe, the overall relative performance of the U.S. markets would argue that investors continue to believe the situation here is significantly more constructive than in most other countries.

Last week, the Labor Department reported that initial jobless claims dipped to 366K, the lowest level since May 2008. While claims only account for one side of the employment equation (firings), their downward trend, coupled with the improving economic environment, suggests that payroll growth should continue to show gradual improvement over the coming months. Meanwhile, two regional manufacturing indices (Empire and Philly) rebounded sharply from recent lows suggesting that overall manufacturing activity continues to strengthen.

Other developing tailwinds include the decline in mortgage rates, which according to Freddie Mac fell to 3.94% in the week ended December 15, matching the lowest level on record. In addition, gasoline prices continue to retreat. According to the American Automobile Association (AAA), the average price of regular unleaded gas fell to $3.25/gallon as of Thursday, the lowest since last February.

The recent uptick in economic data has resulted in many economists revising their Q4 GDP estimate sharply higher. The most recent Bloomberg survey shows the consensus at 2.8% growth (up from 2% in October), however, over recent weeks many top-tier economists have been ratcheting their forecasts closer to the 3.5% area, potentially resulting in the strongest pace of growth since the second quarter of 2010.

FOMC Meeting
The final Federal Open Market Committee (FOMC) of the year was held last week. As expected and what is generally common practice at this time of year, the Fed refrained from making any changes to monetary policy. The committee left the Fed Funds Rate unchanged at 0.0%-0.25% and reiterated their commitment to keeping rates low through mid-2013. They expect a moderate pace of economic growth over coming quarters and consequently anticipate that the unemployment rate will decline gradually toward levels that are consistent with their dual mandate. The committee also noted that strains in global financial markets pose significant downside risks to the economic outlook. The after-meeting statement also noted that they will continue to assess the economic outlook in light of incoming information and remain prepared to employ tools to promote a stronger economic recovery with in a context of price stability.

While there have been growing expectations that the Fed would rollout a revamped communication program, the timing is more likely to coincide with the January meeting, when the Fed is schedule to release its quarterly economic expectations report. In addition, the make-up of the Fed is set to change at the beginning of the year with three of the more hawkish members—Kocherlakota, Plosser and Fisher—all dropping out of the Fed’s voting rotation. The change should help lessen any resistance to a more accommodative stance and will likely open the door to another round of quantitative easing (i.e. QE3) during the year.

Looking Ahead
Data and news flow is expected to be light in the upcoming week although the economic calendar does have a few notable releases. Housing will be a focal point with housing starts, building permits, mortgage applications, existing home sales, and new home sales all being released. The final revision to the 3Q GDP will be released on Thursday with economists expecting the number to hold steady at 2.0%. After two straight weeks of sharp drops, Thursday’s initial jobless claims release will be monitored very closely. The earnings calendar is expected to be modest with only 13 members of the S&P 500 scheduled to report results.

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 a resolution to the debt problems in Europe will be found, that monetary policy will remain accommodative, and that no major fiscal policy mistakes are made. An adverse outcome to 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 Empire State Manufacturing Index is a survey of Manufacturing activity in the Fifth Federal Reserve District (It covers New York State, the 12 northern counties of New Jersey and Fairfield County in Connecticut.). It attempts to index economic activity by polling participants in regards to shipments, new orders, capacity utilization, employment, inventory, and raw materials.

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.

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.