Threat of Credit Downgrades Pares Market Gains

Week in Review: 1/9/12 – 1/13/12

The major market indices finished higher for a second consecutive week.

Performance for Week Ending 1/13/12:

The Dow Jones Industrial Average (Dow) gained 0.50%, the Wilshire 5000 Total Market Index^SM (Wilshire 5000^SM) rose 1.04%, the Standard & Poor’s 500 Index (S&P 500) added 0.88% and the Nasdaq Composite Index (Nasdaq) tacked on 1.36%. Sector breadth was positive as seven of the 10 S&P sector groups finished higher. The Materials sector (+3.93%) was the best performer, while the Energy sector (-1.24%) was the worst. The Canadian market, as measured by the S&P/TSX Composite Index, gained 0.35%.

*See Bottom of the Page for Index Definitions

MARKET OBSERVATIONS: 1/9/12- 1/13/12

The major market indices finished the week modestly higher after solid gains early in the week were pared on news that rating agency Standard and Poor’s planned to lower the credit ratings on a host of European nations. While the action has been talked about for some time, the timing seems to have caught some investors off guard. 

Not to diminish the severity of the credit downgrades but the event should ultimately remove a layer of uncertainty that has been overhanging the markets for quite some time. In addition, the action should be viewed as a harsh reminder to European policymakers that the longer they wait to reach a resolution on the debt crisis, the worse things may get. The euro zone has already likely entered into a recession, the question now becomes whether it will be short and shallow or deep and extended. The ball remains in policymakers’ hands. 

While the issues in Europe remain front and center, the U.S. economy continues to gain traction. Recent signs that the overall environment continues to strengthen include the better than expected gains in December payrolls, an 8-month high in consumer confidence, the downward trend in initial jobless claims, a sharp uptick in consumer credit, and the continued expansion in the ISM Manufacturing and Non-manufacturing sectors. Other tailwinds include the drop in mortgage rates to all-time lows, which should in turn help with the continued stabilization in the housing sector. 

Q4 Earnings Season Kicks Off
Fourth quarter earnings season kicked off last week when Dow-component Alcoa reported results on Monday. Overall, results are off to a shaky start, but better clarity is expected to emerge during “peak” reporting season over the next two weeks. According to Bloomberg, analysts are currently forecasting a 4.6% quarterly earnings gain for the S&P 500, a sharp slowdown from recent quarters and a fraction of the 14.1% they were estimating at the start of October. 

While year-over-year comparisons are becoming tougher due to the strong pace of earnings growth we’ve had over the past several quarters, we must also point out that analysts have also sharply underestimated earnings growth during that time frame. The question becomes whether analysts have once again become too pessimistic on corporate earnings power. In addition, as recently noted by Strategas Research, fourth quarter negative preannouncements have so far outpaced positive preannouncements by a 3.3 to 1 margin. Paradoxically, the reduced expectations and the high negative preannouncement ratio, in the face of improved economic data, may actually become a positive catalyst as there now appears to be plenty room for upside surprises—stay tuned. 

While earnings results will be watched very closely, investors will also pay added attention to forward-looking statements. Of interest will be how corporate managers expect rising energy costs, the strength in the dollar, and the economic weakness in Europe to impact their businesses. 

Beige Book offers a Brighter Outlook
Last week’s release of the Beige Book report underscored that the economic situation in the U.S. continues to improve. The report, which provides anecdotal information collected by the 12 Federal Reserve district banks, noted that overall economic activity expanded at a modest to moderate pace. Consumer spending picked up with most districts seeing significant year-over-year gains in holiday retail sales. Overall, real estate activity remained soft; however, some districts did report improving conditions. In general, banks saw an uptick in loan demand and improvements in overall credit quality. Upward price pressures and price increases remained quite limited and wage pressures were modest overall. 

Looking Ahead
Fourth quarter earnings season will be front and center over the next two weeks as 172 members of the S&P are scheduled to report results. Readings on housing, manufacturing, and inflation will be the focal points of this week’s economic calendar. On the Fed front, speeches by Fed Presidents will be minimal this week reflecting the quiet period ahead of next week’s FOMC meeting. 

MARKET VIEWPOINT 

I continue to believe that the U.S. equity markets remain well positioned for positive performance over the course of 2012. This 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.

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.