Money Matters with Rose Greene » stock market

LPL Financial Weekly Market Commentary for April 24, 2012

Rose Greene, CFP — Tue, 24 Apr 2012 21:17:48 +0000

Spring Allergies or Something Worse?

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

In April, the markets seem to be suffering from a case of spring allergies. Like pollen-induced sneezes, the spasms at each of the data points have resulted in a noticeable uptick in volatility after a very quiet first quarter.

The symptoms are not likely to clear up this week with many allergens floating around: the Fed meeting, first quarter earnings reports, key economic data, the French elections, the worsening recession in Europe, and earnings reports from Spanish banks.

Investors’ immune systems may be hypersensitive after the past five years. But the market’s symptoms may also be signs of an oncoming illness potentially leading to a sustained pullback.

In April, the markets seem to be suffering from a case of spring allergies. One day they are feeling better and climbing higher, the next they weaken and drop. Like pollen-induced sneezes, the almost involuntary market spasms at each of the data points have resulted in a noticeable uptick in volatility after a very quiet first quarter. In fact, so far during April nearly half of the trading days, six out of 14, have seen more than a 1% swing in the S&P 500. This is just one day less than the seven 1% swing days in the stock market during the entire first quarter.

The symptoms are not likely to clear up this week. The allergens floating around the U.S. this week that markets may react to include: the Fed meeting, first quarter earnings reports, and key economic data.

The Fed may not offer enough insight on a potential QE3 — a third round of quantitative easing — that investors seem to be looking for after recent economic data.
First quarter earnings reports thus far generally exceeded analyst estimates by a wide margin without material downward revisions to upcoming quarters’ estimates. Yet the stock market, as measured by the S&P 500, was up only about 0.6% last week and investors’ bar of expectations may now be even higher as the earnings reporting season nears the halfway point later this week.
Among the economic data released this week, initial jobless claims will be closely watched to see if they make a third consecutive week of deterioration and qualify as red flag number five out of our 10 leading indicators of another spring slide in the stock market and other “risk assets.” (See the Weekly Market Commentary “10 Indicators to Watch for Another Spring Slide” from March 26, 2012 for more details).

The real test for the markets this week may come from overseas as markets react to: the French elections and accompanying policy uncertainty, the recession worsening in Europe, and finally Spanish banks will report their earnings.

We will have to see what Socialist Party candidate Francois Hollande’s victory in the first round French presidential election on Sunday, April 22 means to European politics and the French-German relationship in leading the unified anti-crisis programs. Hollande’s socialist political ideology may make for a difficult relationship with Germany’s right-leaning Chancellor Angela Merkel. In addition, French domestic politics could change with
higher spending proposals likely under Hollande — he has stated an intention to renegotiate European treaties on deficit limits — and could push French bond yields higher.
As the European recession deepens — evidenced this week by a disappointing European manufacturing report for April — for the first time since before Japan entered its multi-decade slump, German 2-year bond yields have dipped lower than those of Japan, at around 0.1%. This decline in 2-year yields to near zero reflects both a flight to quality within Europe, as money leaves Spanish and Italian bonds, and a deteriorating outlook for growth. The specter of a lost decade is overhanging Europe as it echoes the post-bubble Japanese economy in the 1990s defined by troubled banks, a deepening recession, a volatile stock market, and very low yields.
Many Spanish banks will report first quarter earnings this week, including heavyweights Banco Popular, Santander, and BBVA. Spain’s problems lie largely with its banks. Markets have been pricing in an increasing probability of a bank default in recent weeks, suggesting injections of capital may be necessary. Investors will be looking for the scope of the damage to balance sheets resulting from the ongoing real estate declines and recession along with the accompanying need for government capital. The scrutiny will be intense, with Spanish 10-year bond yields back up to around 6% from as low at 4.8% in February, despite the International Monetary Fund (IMF) getting pledges for an even bigger financial crisis backstop.

Investors’ immune systems may be hypersensitive after the past five years. But the market’s symptoms may also be signs of an oncoming illness. Despite worries, stocks climbed 30% during the past two quarters. With volatility now returning and the market advance becoming led by fewer stocks (the average S&P 500 stock is stuck at the level reached in early February), further signs are emerging in market behavior that it may be vulnerable to a pullback.

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IMPORTANT DISCLOSURES

LPL Financial Weekly Market Commentary for April 17, 2012

Rose Greene, CFP — Tue, 17 Apr 2012 20:32:21 +0000

A Taxing Issue for Investors

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

Perhaps surprisingly, it appears that the tax rate changes have played little or no direct role in stock or bond market performance.

The most likely reason is that the effects on after-tax returns were deemed negligible relative to the macroeconomic and geopolitical drivers.

The far bigger impact is an indirect one determined by the magnitude and direction of overall fiscal policy taken (or not taken) in 2013 to put the United States back on a path to financial stability.

This Tuesday, April 17, is tax day — and it may never be the same. The 2012 elections hold major consequences; one of them is tax policy. While there is much that we could present regarding the potential changes, we will constrain our comments to how tax changes may directly affect investors in the stock and bond markets.

Already written into law for 2013 are big changes including the expiration of the Bush tax cuts and the payroll tax cut and the new Medicare tax on investment income, not to mention the impact of the increasingly costly annual fix to the alternative minimum tax. However, this default option may instead be replaced by something else.

President Obama has devoted a lot of his recent campaigning to highlighting his preference for the so-called “Buffet rule,” which places a top minimum tax rate on capital gains of 30% and, combined with other changes, produces a top rate of 43.4% on dividends and interest income.
Alternatively, included in the Mitt Romney supported House Republicans’ proposal is a cut to the top income tax rate that would apply to interest income to 25% and maintain the 15% rate on dividends and capital gains.

The outcome is likely to be somewhere in the middle of the wide range between these two proposals. Given the scale of the changes, it may be surprising to note that we do not expect major direct impacts of tax changes on the stock or bond market. The far bigger impact is an indirect one determined by the magnitude and direction of overall fiscal policy taken (or not taken) in 2013 to put the United States back on a path to financial stability.

Bond Market Tax Rate Impacts

Historically, changes in income tax rates that apply to interest income appear to have had little, if any, direct impact on government bond yields. Yields rose with inflation in the 1970s and fell as inflation fears receded over the vast majority of the last 30 years regardless of tax code changes or their impact on the deficit.

Over the past 30 years, municipal bond yields traditionally traded at a discount to taxable bond yields. However, in recent years credit fears driven by macroeconomic events have resulted in a breakdown of the historic spread between taxable and non-taxable municipal bonds. Municipal bonds now trade at yields in line or above those of their taxable Treasury counterparts. The potential for higher income tax rates applied to interest income is likely to make municipal bonds even more attractive to investors as credit fears fade.

Stock Market Tax Rate Impacts

Tax changes have also had minimal effects on stock market performance. To illustrate, we can look at the two most important drivers of stock market return: earnings growth and valuations.

Generally, higher taxes mean less of an incentive for individuals to work, invest, take risks to create value and become entrepreneurs. It can also mean less disposable income to spend on goods and services. However, income tax changes have not had much measurable effect on earnings growth.

Earnings growth is very cyclical — it falls sharply during recessions and rebounds early in expansions to average about a 7% growth rate over the full cycle. This has been consistent regardless of the prevailing tax rates. In fact, the growth rate of earnings from the peak of one business cycle to the next has consistently been about 7% over the six major earnings cycles spanning the past 50 years, despite average top marginal income tax rates that ranged from 91% at the beginning of the period to the current 35% and corporate tax rates that ranged from 52.8% to 34%.

With no discernible effect on earnings growth, what about the impact of tax rates on valuations? Certainly, tax rates have the ability to directly impact the value investors place on the stock market. In theory, stocks are valued by investors based on expected total return, net of applicable taxes. For example, if dividend and capital gains taxes were each set at 100%, stocks would have little value to a taxable investor. It is reasonable to believe that the lower the tax rate, the more a taxable investor would value stocks up to that of a non-taxable investor.

However, over the past 30 years, higher effective federal income tax rates for the top 20% of earners (who tend to make up the majority of individual investors) have not resulted in lower stock market valuations, measured by the price-to-earnings ratio for the S&P 500 index. Counter-intuitively, periods of higher valuations occurred during periods of higher effective tax rates and lower valuations occurred when tax rates were lower. Much of this can be explained by cyclical factors. For example, in the late 1990s, stock market valuations rose to record highs despite relatively high marginal and effective tax rates.

Based on our analysis of the tax debate in Washington, we place the highest probability on the dividend and capital gains tax rates both rising to 20 – 30%. However, a reversion to the much higher rates that preceded the Bush tax cuts or a one-year extension of all current tax rates of 15% are also possible outcomes.

One reason the direct impact of tax rate changes may be muted is that it appears that stocks may already reflect the return of higher tax rates. One way we can see this is to look back at prior periods with similar tax rates and what it may imply for 2013. If we average the historical top dividend and capital gains tax rates together, we find that during the post-WWII period a 25 – 30% combined investor tax rate was in effect only during 1991 – 92 and 1997 – 2002. During the later period, stock market valuation was at record highs well above current levels and do not serve as a good comparison due to the impact of the internet bubble distorting the overall market value. However, 1991 – 92 may offer a comparable period for analysis. During this period, the macroeconomic and geopolitical backdrop included the aftermath of the S&L crisis, sluggish U.S. economic growth, a European recession, the geopolitical risks surrounding the first Gulf War, and pessimistic consumers.

During this 1991 – 92 period, the average top dividend and capital gains tax rate was between 25% and 30%, and stock market valuation, measured by the price-to-earnings ratio on the next twelve months expected earnings for the S&P 500 companies, was about 15. This figure is above the current forward price-to-earnings ratio of about 13. What this suggests is that while there are many factors that affect stock market valuation, the direct impact of the potential for higher tax rates on dividends and capital gains may already be discounted by the market.

Investor Tax Rate Changes

It seems that the bond and stock markets have adjusted to different tax rates without any apparent long-term direct effects on performance. But what about during short-term periods when those rates were changed, did markets have abrupt adjustments to the changes in rates? The answer is no; history shows that the markets took the changes in stride.

For example, the capital gains tax rate went from 20% to 28% for 1987 when the 1986 tax reform act was passed, and that did not stop a rally in stocks beginning as the act was passed that lasted for most of 1987 (until the unrelated October 1987 crash).

In addition, the market impact of the investor tax cuts in 2003 that lowered dividend and capital gains tax rates to 15% was difficult to discern, given the geopolitical and economic environment at the time, and the impact of the reversal of these provisions may be equally difficult to discern separately from their macro context. We can see this difficulty by looking back at the stock market’s reactions to the news of the proposed investor tax cut and then the passage of those cuts:

Initial details of the 2003 investor tax cuts began to appear in early December of 2002 with a statement from President Bush providing further insight into the package of tax cuts on January 7, 2003. Stocks slumped in December and January — even around the days details came to light — as investors were focused on the impending invasion of Iraq. The performance of both non-dividend paying and dividend-paying stocks was very similar, despite the prospects for a cut in the dividend tax rate.
Attention returned to the tax cuts in April 2003, as competing bills with various provisions moved through both houses of Congress. There was much uncertainty as to what the final tax cut elements were to be and whether any investor tax cuts were going to be passed. The tax bill narrowly passed in mid-May with Vice President Cheney breaking the tie in the Senate. The package including the investor tax cuts was signed by the President on May 28, 2003. As you can see in Chart 2, in April and May (and over the rest of the year), the stocks of low or no dividend-paying companies outperformed high dividend payers as stocks rallied powerfully and the invasion of Iraq got underway.

During both of the above-referenced periods, U.S. and non-U.S. stocks also performed very similarly, with the world focused on Iraq. The impact of the investor tax cuts in the U.S. did not result in U.S. stock market outperformance. Also, low and non-dividend paying stocks outperformed the high-dividend payers that would benefit most from the lower dividend tax rate.

It appears that the tax rate changes have played little or no direct role in stock or bond market performance. Possible reasons may be that investors discounted the effect since changes were not made permanent or, more likely, that the effects on after-tax returns were deemed negligible relative to the macroeconomic and geopolitical drivers.

We believe the heightened attention on taxes and the deficit is more of a concern than in prior episodes of tax rate change. The direction of the markets is dependent upon substantive action taken to address the debt ceiling, potential debt downgrades, and fiscal stability with any change in tax rates likely to be secondary to how successfully the challenges are addressed.

Year-End Effects

While history suggests otherwise, given that a lame duck session after the election is unlikely to result in enough time or cohesion to adjust tax rates before they change, investors might take action around year-end to take advantage of expiring low tax rates. As the year-end expiration of the 15% capital gains tax rate looms, investors might be prompted to sell to lock in the 15% rate. Also, a potential outcome of the year-end dividend rate tax hike could be a large number of public companies with a high concentration of family and closely held shares declaring and making a one-time, special dividend payment in the fourth quarter to be sure to take advantage of the 15% tax rate before it goes away.

To download a complete copy of the commentary click here

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guaran¬tee that strategies promoted will be successful.
Stock investing may involve risk including loss of principal.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply.

LPL Financial Weekly Market Commentary for March 27, 2012

Rose Greene, CFP — Tue, 27 Mar 2012 20:58:36 +0000

10 Indicators to Watch for Another Spring Slide

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

In each of the past two years the stock market began a slide in the spring that lasted well into the summer months.

We have identified 10 indicators to watch closely in the coming weeks that may warn of an impending slide.

So far, about half of the 10 indicators point to a repeat of the spring slide this year, while the other half do not.

In each of the past two years the stock market began a slide in the spring, a phenomenon often referred to by the old adage “sell in May and go away,” which lasted well into the summer months. Are stocks poised to repeat the pattern this year? We have identified 10 indicators to watch closely in the coming weeks that may warn of an impending slide.

What to Watch

In both 2010 and 2011 an early run-up in the stock market, similar to this year, pushed stocks up about 10% for the year by mid-April. On April 23, 2010 and April 29, 2011, the S&P 500 made peaks that were followed by 16 – 19% losses that were not recouped for more than five months. While late April is still four weeks away, judging by what indicators seemed to precede the declines in 2010 and 2011, we have identified 10 indicators to watch over the next four weeks.

The 10 indicators include:

1. Fed stimulus – In each of the past two years, Federal Reserve (Fed) stimulus programs known as QE1 and QE2 came to an end in the spring or summer and stocks began to slide until the next program was announced. The current program known as Operation Twist was announced on September 12, 2011 and is scheduled to conclude at the end of June. The stock market may again begin to slide until another program such as QE3, the scope of which was recently hinted at by the Fed, is announced.

2. Economic surprises – The Citigroup Economic Surprise index [Chart 2] measures how economic data in the United States fared compared to economists’ expectations. A rising line indicates that the data is consistently exceeding expectations. A falling line suggests expectations have become too high. The index moved to what has historically marked the peaks in optimism about a month or two before the peaks in the stock market in 2010 and 2011. This year, it appears the index may have already started to retreat from a peak since early February; if this index again leads by two months the slide may soon begin.

3. Consumer confidence – In 2010 and 2011, early in the year the daily tracking of consumer confidence measured by Rasmussen [Chart 2] rose to highs last seen on September 5, 2008, just before the stock market collapse as the financial crisis erupted. The peak in optimism gave way to a sell-off as buying faded. Investor net purchases of domestic equity mutual funds began to plunge and turned sharply negative in the following months. This measure of confidence is once again close to the highs seen in early 2010 and 2011; we will be watching for a turn lower in the index that would indicate the start of an erosion of confidence.

4. Earnings revisions – The first couple of weeks of the first quarter earnings season (April 2010 and April 2011) drove earnings estimates higher in both 2010 and 2011. Earnings estimates for S&P 500 companies over the next year rose a greater-than-average 3 – 5% over the first couple of weeks of reports. But as the second half of the earnings season got underway in May 2010 and May 2011, guidance disappointed analysts and investors as the pace of upward revisions declined sharply. This year, we will be watching to see how much earnings expectations rise as the initial reports come in and if they begin to taper off sharply.

5. Yield curve – In general, the greater the difference, or spread, between the yield on the 2-year and the 10-year U.S. Treasury notes, the more growth the market is pricing into the economy [Chart 2]. This yield spread, sometimes called the yield curve because of how steep or flat it looks when the yield for each maturity is plotted on a chart, peaked in February of both years at 2.9%. Then the curve started to flatten, suggesting a gradually increasing concern about the economy. This year the market is pricing a more modest outlook for growth, but we will be watching to see if the recent slight decline in the spread (currently about 190 basis points) begins to decline.

6. Oil prices – In 2010 and 2011, oil prices rose about $15 – 20 from around the start of February, two months before the stock market began to decline. This year oil prices have climbed back to the levels around $105 – 110 that they reached in April of last year. However, they have risen only about $10 since around the start of February 2012. A further surge in oil prices would make this indicator more worrisome.

7. The LPL Financial Current Conditions Index (CCI) – In 2010 and 2011, our index of 10 real-time economic and market conditions peaked around the 240 – 250 level in April and began to fall by over 50 points. This year, the CCI recently reached 249 and has started to weaken and currently stands at 232.

8. The VIX – In each of the past two years the VIX, an options-based measure of the forecast for volatility in the stock market, fell to a relatively low 15 in April. This suggested investors may have become complacent and risked being surprised by a negative event or data. This year, the VIX has recently declined once again to 15 in the past two weeks.

9. Initial jobless claims – It was evident that initial filings for unemployment benefits had halted their improvement by early April 2010, and beginning in early April 2011, they deteriorated sharply. So far, in 2012 initial jobless claims continue to improve at a solid pace, but it may yet be too early, and so we will be watching for any weakening as April gets underway.

10. Inflation expectations – The University of Michigan consumer survey reflected a rise in inflation expectations in March and April of the past two years. In fact, in 2011, the one-year inflation outlook rose to 4.6% in both March and April. This year, inflation expectations have also jumped higher so far in March, reaching 4%.

While this list may seem incomplete, it is notable that many of the most widely watched indicators of economic activity such as manufacturing (the Institute for Supply Management Purchasing Managers Index known as the PMI or the ISM), job growth, and retail sales, among others, did not deteriorate ahead of the market decline, but along with it. It is not that they are not important; it is just that they did not serve as useful warnings of the slide to come, while the above indicators did.

So far, about half of the 10 indicators point to a repeat of the spring slide this year, while the other half do not. We will continue to monitor these closely in the coming weeks.

Shorter Slide?

While it is possible we will experience another spring slide this year, there are factors that may mitigate the decline short of the 16 – 19% seen in the past two years.

Looking back, in 2010 the negative environment that helped fuel the decline included the end of the Fed’s QE1 stimulus program, the uncertainty around the impact of the Dodd-Frank legislation, the eurozone debt problems and bailouts, central bank rate hikes, and the end of the homebuyer tax credit. In 2011, the negatives included the end of the Fed’s QE2 stimulus program, the Japan earthquake and nuclear disaster that disrupted global supply chains and pulled Japan into a recession, the Arab Spring erupted pushing up oil prices, the budget debacle and related downgrade of U.S. Treasuries, rising inflation, central bank rate hikes, and the eurozone debt problems coming to a head.

Looking ahead, the negatives we face in 2012 already include the end of the Fed’s Operation Twist stimulus program, rising oil prices, China’s slowdown, the European recession, the election uncertainty, and anticipation of the 2013 budget bombshell of tax hikes and spending cuts. However, there are some positives this year that may help offset some of the negatives making for a potential decline that may be less steep than those of the past two years. First, central banks are now cutting rather than hiking rates, which should help to temper global recession fears evident during the past two years’ spring slides. Second, housing is showing signs of improvement as both new and existing home sales are rising at about a 10% pace. Third, while energy prices are up this year (same as last year) food prices are decelerating, which helps to explain why consumer sentiment is going up in the face of higher gasoline prices. Finally, auto production schedules are robust for the next quarter and likely to support
manufacuring activity, which had fallen in May through July of the past two years and contributed to the market decline.

Given this year’s double-digit gains and the possibility of another spring slide for the stock market, investors may want to watch these indicators closely for signs of a pullback despite the current upward momentum in the stock market and solid economic growth.

To download a complete copy of the commentary click here

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guaran¬tee that strategies promoted will be successful.
International and emerging markets investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.
Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Standard & Poor’s 500 Index is an unmanaged index, which cannot be invested into directly. Past perfor¬mance is no guarantee of future results.
Citigroup Economic Surprise Index (CESI) measures the variation in the gap between the expectations and the real economic data.
The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexam¬ined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
Yield Curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.
The VIX is a measure of the volatility implied in the prices of options contracts for the S&P 500. It is a market-based estimate of future volatility. When sentiment reaches one extreme or the other, the market typically reverses course. While this is not necessarily predictive it does measure the current degree of fear present in the stock market.
Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

LPL Financial Weekly Market Commentary for March 13, 2012

Rose Greene, CFP — Tue, 13 Mar 2012 20:24:17 +0000

Best Bull Market Ever…Now What?

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

The three-year anniversary of the bull market took place on Friday, March 9. This has been the strongest bull market since WWII.

The average return in year four of prior bull markets was 12.9%, close to our 8 – 12%* return expectation for 2012.

While the stock market faces significant challenges ahead, we expect another year of gains for stocks. But that gain may be accompanied by the return of volatility.

The three-year anniversary of the bull market took place on Friday, March 9. In the three years since March 9, 2009, the S&P 500 index is up 103% (with a 116% total return including dividends). This has been the strongest bull market since WWII [Chart 1].

So, after doubling in three years what is next for the bull? More gains, when using history as a guide. The average return in year four of bull markets was 12.7% (six of the 10 post-WWII bull markets lasted that long). While a slightly different time period, this historical average for year four (March 9, 2012 – March 9, 2013) is very close to our 8 – 12%* return expectation for stocks in calendar year 2012. Interestingly, only one bull market ended in year four. That was in February 1966, and the S&P 500 renewed its advance eight months later, recouping the losses after about a year. The average bull market lasted 58 months, just short of five years.

While corporate earnings have been a key driver of stocks, the return of economic growth and the confidence in the durability of that growth have also been important. The bull market has been rising as recession fears have faded. In fact, the path of the S&P 500 and the Google search trends for the word recession are a nearly perfect mirror image of each other, as you can see in Chart 2.

While the stock market faces significant challenges ahead, we expect another year of gains for stocks. But that gain may be accompanied by the return of volatility. Already stocks have surged 9% this year (through Friday, March 9, 2012), within the range of our 8 – 12%* return forecast. In the near term, we believe a modest pullback may be in store for the stock market driven by a combination of factors:

The Worst Earnings Season in Years – Earnings have mattered a lot for the stock market. Since the end of 2008, S&P 500 companies’ earnings are up about 50%, and the S&P 500 is up about 50%. That one-to-one relationship is no coincidence. With such a heavy reliance on earnings growth, stocks are vulnerable to declines with earnings growth now appearing to stall. Earnings growth in the first quarter of 2012 will likely be flat on a year-over-year basis, the worst showing in a year.
High Economic Expectations – The economic surprise index is near prior peaks, suggesting the bar of expectations is high and economic data is much less likely to surprise to the upside and risks disappointing the market. Rising gasoline prices and relatively flat incomes, along with slowing global growth, raise the risks.
Central Banks Stimulus Ending – The Federal Reserve (Fed) and the European Central Bank (ECB) policy actions are coming to an end. The ECB has completed their refinancing operations and the Fed’s Operation Twist is set to end in June of this year — the end of the Fed’s former programs QE1 and QE2 prompted market sell-offs in the past two years.
The Budget Bombshell – The prospects for divided government in 2013 have increased given the latest Senate race polling data. This is critical to the economic outlook. The 2013 budget is already going to have the biggest impact of any budget in decades even if no action is taken in Washington. The fiscal headwind comprised of both tax increases and spending cuts under current policy totals over $500 billion, or 3.5% of GDP. The 2013 budget changes, primarily consisting of tax increases, are already in the law and would need to be changed to mitigate or restructure them to be less of an economic drag; if not a return to recession may be looming in 2013.
The Greece Fire – The risk of a grease fire is that it is hard to put out and spreads easily. The market welcomed this week’s news of an orderly default for Greece’s private debt holders (finding it much more attractive than the alternative). However, Greece is still feeling the heat with new bonds trading at 20%, and Portugal stands next in line for a second bailout and a debt restructuring. Portuguese 10-year bonds are trading at about 50 cents on the dollar, reflecting the significant likelihood of default risk having spread beyond Greece. A deepening recession in Europe also raises the risks to investors beyond Europe’s borders as demand weakens, affecting both U.S. and emerging market suppliers.

This week kicks off year four of the bull market. Year four will challenge the S&P 500 to take the crown once again as the best performing bull market given the strong performance of the bull market of the mid-1980s, yet there are potential positives that could drive such strong gains. Most notably, stock market valuations are below average. Each point that the price-to-earnings ratio rises (or falls) is about a 7% gain (or loss) for the market. A rise in this ratio in 2012 as the above challenges are overcome could result in powerful gains and sustain the best bull market in history for yet another year.

To download a complete copy of the commentary click here

IMPORTANT DISCLOSURES

LPL Financial Weekly Market Commentary for March 7, 2012

Rose Greene, CFP — Wed, 07 Mar 2012 22:27:42 +0000

Arab Spring 2

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

This year, oil prices have started off on a similar path to last year, but disturbingly are already about $10 higher than they were last year.

Oil prices have climbed to just below the threshold where demand for oil has weakened in the past, suggesting a negative impact on economic growth.

The combination of rising prices sapping consumer spending power and the deteriorating earnings outlook paint a negative picture for the markets. However, with prices already high, a resolution to geopolitical talks or added supply from other sources may provide some relief.

Hollywood has a thing for sequels. So do the markets. In recent weeks, we have pointed to the rise in the stock market and the euro early this year as mirroring those gains of early 2011. While stock market gains and currency moves can certainly grab headlines, they lack the drama of a move in oil prices. The move higher in oil prices so far this year is similar in pattern to last year’s surge, but the story is a bit different this time.

Last February, a series of uprisings that began in four middle-eastern countries started to push oil prices higher. While the uprisings began in December 2010 and in January 2011 the Tunisian President fled to Saudi Arabia, the so-called “Arab Spring” protests started to gain momentum and affect world oil markets in February as Egyptian President Hosni Mubarak resigned after 30 years as Egypt’s ruler. Protests quickly spread to Libya, Bahrain, Iraq, Kuwait, Jordan, Yemen, and Syria, among others. In the U.S. oil prices reached $114, but in Europe where markets are more dependent upon oil from middle-eastern countries oil (Brent crude), prices soared to about $126.

This year, oil prices have started off on a similar path to last year, but disturbingly are already about $10 higher than they were last year. The increasing tensions in the Middle East centered on Iran’s nuclear program and the pressure being applied by the imposition of EU (European Union) and Japanese sanctions on Iranian oil have led to another “Arab Spring”-type pattern in oil prices.

Rising oil prices are adding a risk to the markets and the economy. As you can see in Chart 2, oil prices have climbed to just below the threshold where demand for oil has weakened in the past, suggesting a negative impact on economic growth.

Fortunately, weekly retail sales show that there is no discernible effect on consumer spending yet with sales rising at a 2.7% pace in the latest week compared to a year ago, as depicted in Chart 3. However, the drag of higher oil prices may be offset by unusually warm weather pulling spring sales forward.

Of course, consumers do not buy crude oil, they buy gasoline. The latest data from the U.S. Department of Energy, reported for February 27, reveal that the national average retail gasoline prices have risen 50 cents to $3.78 since mid-December 2011, when prices averaged $3.29. Gasoline prices may continue to edge higher unless crude oil prices recede.

High crude oil input costs and potentially slackening demand are not boosting earnings for the Energy sector. Consensus earnings forecasts for the Energy sector have been revised downward and are now expected to be flat versus year-ago levels, down from an 8% gain expected when the quarter began. In addition, earnings for the Consumer Discretionary sector are also falling — though in line with expectations for the overall S&P 500 — with growth estimates having been cut in half from around 6 – 7% to about 3% for the first quarter.

The combination of rising prices sapping consumer spending power and the deteriorating earnings outlook paint a negative picture for the markets. However, with prices already high, a resolution to geopolitical talks or added supply from other sources may provide some relief.

Geopolitical Breakthrough – A breakthrough on geopolitical talks with Iran may reverse oil prices. Iran is the second-biggest producer in OPEC and makes up about 5% of world oil production. The imposition of new sanctions by EU nations is having a broader effect on Iranian exports, since tanker owners are having trouble getting insurance from European insurers to carry Iranian crude to any destination. Inflation in Iran is running at 21%, resulting in some domestic dissatisfaction bound to worsen in the coming months. This past weekend’s legislative elective elections in Iran may clear the way for compromise.
Additional OPEC Supply – In the meantime, OPEC is expected to have 2.5 million barrels per day of excess supply to help cover lost exports from Iran. It appears that Saudi Arabia, the country with the excess capacity in OPEC, is stepping up production. Baker Hughes reported that Saudi Arabia is deploying the most oil rigs in four years. The number of rigs used more than doubled in January to 49 from 23 a year earlier, the biggest annual increase on record. But the total still stands below the 57 in August 2007.
Emergency Release of SPR – In addition, members of the Democratic party are urging President Obama to release oil from the Strategic Petroleum Reserve (SPR) used in response to high oil prices due to disruptions or geopolitical events that often take place during election years (1996, 2000, 2004, 2008).

Hopefully, the sequel to the Arab Spring ends with oil prices coming back down as they did last year without damaging demand or fragile consumer and investor sentiment.

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IMPORTANT DISCLOSURES

LPL Financial Weekly Market Commentary for February 14, 2012

Rose Greene, CFP — Tue, 14 Feb 2012 20:21:15 +0000

The Worst Earnings Season in Years Still Beats Expectations

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

Earnings have mattered a lot for the U.S. stock market. Over the past three years, earnings are up about 58% and the S&P 500 is up about 55%.

Yet, in recent weeks, stocks have been rising even as earnings estimates have been falling, and fourth quarter earnings growth was the slowest it has been in years. This is largely because investors were even more pessimistic.

Key drivers of earnings can tell us about the durability of earnings growth. During this earnings season we have been paying special attention to revenues and business spending.

Earnings have mattered a lot for the U.S. stock market. Over the past three years, earnings are up about 58% and the S&P 500 is up about 55%.* That one-to-one relationship is no coincidence. Stock market valuations, measured by the price-to-earnings ratio — or what investors are willing to pay per dollar of current earnings — have not changed over the past few years and remain around 13 for the S&P 500, well below the long-term average. The relentless climb in earnings has been what has pulled stocks higher over the past three years, not increasing optimism in the durability of the business cycle.

With such a heavy reliance on earnings growth, are stocks vulnerable to declines with earnings growth now appearing to stall? It would appear so based on the statistics. With 70% of companies having reported, the earnings growth rate for the S&P 500 for the fourth quarter 2011 is about 8%. This is the slowest earnings growth rate since the recovery in earnings began over two years ago.

This 8% growth rate is half of what it was expected to be at the beginning of the fourth quarter. As October of last year got underway, earnings per share were expected to be up 15% from a year earlier. Next quarter (first quarter of 2012) earnings growth is now expected to slide to a gain of just 3% year-over-year, down from expectations for a 10% gain at the start of the fourth quarter of 2011.

Moreover, just 63.9% of companies that have reported results for the fourth quarter of 2011 have beaten the lowered estimates. This is just below the historical average of 66.7% over the past 10 years and the lowest since the eruption of the financial crisis in the fourth quarter of 2008, as you can see in Chart 1.

Looking ahead to the first quarter results, slightly more companies have lowered than raised earnings guidance along with their fourth quarter reports. Of the companies that issued guidance, 52 in the S&P 500 have issued negative guidance compared to only 20 that have issued positive earnings guidance for Q1 2012. The ratio of negative to positive preannouncements of 2.6 is the weakest showing since the worst of the recession in the first quarter of 2009.

Not as Bad as Was Feared

In recent weeks, stocks have been rising even as earnings estimates have been falling and fourth quarter earnings growth was the slowest it has been in years. Fading optimism of analysts and business leaders was offset by fading pessimism among individual investors. The explanation is their expectations were much worse.

Investor, analyst and business leaders’ expectations for earnings are meeting in the middle. This is a key theme for 2012, as many divergent trends of the past year become more in alignment. Earnings estimates have been coming down to be in line with our estimates. Analysts’ expectations for earnings growth for 2012 as a whole were about 13% at the end of last year and now are 8%, very close to our long-held 7% target (as you can see in Chart 2). At the same time, investors had priced into the stock market a decline in earnings in 2012 (valuations started the year in line with where they were last at the end of 1990, during recession when earnings fell 20% over the following six months) and are now realizing that earnings are instead likely to post modest growth in 2012.

Key drivers of earnings can tell us about the durability of earnings growth. During this earnings season we have been paying special attention to revenues and business spending.

With profit margins near peaks, profits will more closely track revenues in coming quarters. With over 70% of S&P 500 companies having reported, revenue growth for the fourth quarter is tracking toward an 8% increase year-over-year, according to Thomson Financial. As expected, demand from emerging markets was a key driver of revenue growth, enabling companies to offset some anticipated softness in Europe. Companies continue to report solid demand from emerging markets; several examples highlighted this trend with their reports last week:

McDonald’s Corporation announced global comparable sales growth for January 2012 driven largely by growth in emerging markets where sales were up over 7%.
While Coca-Cola’s North American and European volumes grew just 1%, China produced a 10% gain and sales volume in India rose 20%.
Yum! Brands’ same-store sales rose 21% in China, compared with 1% in the U.S.

In addition, strong demand continues to come from business spending-oriented sectors such as Industrials and Information Technology. These sectors have the highest growth rates for the fourth quarter of 2012 averaging about 17%, much better than analysts’ estimates. Investor attention is often directed on consumer spending as a driver of profits. However, business-spending-driven sectors are major drivers of S&P 500 profit growth while discretionary consumer spending has a much smaller contribution to the S&P 500. Continued strength in business spending can help drive profit growth in 2012, helping to lift stocks for the year.

Finally, a positive aspect of the earnings season is that dividend growth is making a comeback. The first quarter is when companies most often increase or initiate a dividend. Pressure is building for other companies to increase their dividends as U.S. companies sit on record cash stockpiles and payouts remain at all-time lows. S&P 500 companies paid out about 30% of earnings in the form of dividends in the fourth quarter of 2011 up from 28.7% in the third quarter, down from the average of 30% for much of the 2000s and well below the 30-year average of 40%. We have seen 58 S&P 500 companies increase their dividend so far this year, slightly ahead of last year’s pace. Looking at the broader universe of U.S. stocks, which includes smaller companies, the return of the dividend story is more compelling with a 38% increase in the number of companies issuing dividends over the past year with 188 increases in January 2012 compared to 136 in January 2011, according to data from Standard and Poor’s.

Company cash and equivalents have soared to record highs even as companies have paid down debt in a dramatic deleveraging over the past few years. A continued return to higher dividend payouts would help attract investors seeking income in an environment of very low bond yields. The S&P 500’s dividend yield stands at 2.1%, above the yield on the 10-year Treasury for one of the few times in history.

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IMPORTANT DISCLOSURES

LPL Financial Weekly Market Commentary for January 25, 2012

Rose Greene, CFP — Wed, 25 Jan 2012 21:28:29 +0000

State of the Union Preview

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

President Obama’s State of the Union (SOTU), scheduled for Tuesday, January 24, is unlikely to be a big market mover.

In fact, most SOTU speeches see less than a 1% move in the stock market on the following day.

However, the themes and philosophy presented may shape the market’s movements in the months to come with implications for Financial and Industrial companies and oil prices.

President Obama’s State of the Union (SOTU), scheduled for Tuesday, January 24, is unlikely to be a big market mover. In fact, most SOTU speeches see less than a 1% move in the stock market on the following day and the average move is only 0.14% [Chart 1]. However, the themes and philosophy presented may shape the market’s movements in the months to come.

Rather than break new ground, the SOTU address is likely to echo the President’s December 6 speech in Osawatomie, Kansas. That speech was modeled after President Theodore Roosevelt’s 1910 historic address in that city on economic and social equality that led into 20th century progressivism, the central philosophy of Obama’s presidency.

The many topics of the speech — and their market impacts — can be broken down in terms of what will happen, what will not happen, and what could happen in 2012.

What Will Happen

In the SOTU address, Obama is very likely to highlight the immediate need for Congress to come together to extend the payroll tax cut and unemployment insurance benefits through 2012. In December 2011, a bitterly divided Congress could not come together on how to pay for a year-long extension and so only extended them for two months. We expect Congress to further extend these stimulus measures before they expire at the end of February, but the hostile negotiations — something the markets have had a break from in recent weeks — are likely to garner attention and help to renew market volatility after a remarkably stable advance in the first few weeks of the year.

Regulatory policy, an area where the executive branch is less dependent upon Congress’ leadership, will be a key part of the speech. The President is likely to highlight revamped housing programs, such as the Home Affordable Refinance Program (HARP), and announce a settlement that would end long running negotiations among Obama administration officials, state attorneys general and at least five of the nation’s largest financial services companies over “robo-signing” and questionable foreclosure practices. The settlement could be good news for Financials, one of the top performing sectors this year.

What Will Not Happen

The President is likely to call for increased infrastructure investment in the U.S. economy, including school construction, roads and bridges, and high-speed rails. Congress is unlikely to appropriate the funding to meet the President’s call on these items. Companies in the Industrial sector have performed well so far this year, but do not appear to be pricing in increased domestic infrastructure spending.

Job growth is key to the President’s re-election chances. As you can see in Chart 2, inflation-adjusted, after-tax income growth of about 3% appears to be the threshold for incumbents to get 50% of the popular vote. Currently, this measure of per capita income is only growing at 0.1%.

While factors other than jobs have a bearing on the election, job creation may be the key measure by which Obama’s presidency will be judged. However, much like infrastructure initiatives, measures to stimulate job growth presented in the SOTU are unlikely to be funded.

The President will likely address eliminating the so-called Bush tax cuts for higher earners, especially those making $1 million or more a year. In addition, given the recent attention to Mitt Romney’s tax filings, the President may call for applying income taxes to carried interest. With the President due to release his budget on February 6, he may also address overseas corporate tax breaks. However, with the House in Republican hands, none of these tax proposals will pass this year.

What Could Happen

This SOTU may foreshadow the President tilting his focus away from domestic politics to foreign affairs over the course of 2012. In doing so, he is shifting from the area where the President is institutionally weak (domestic policies) to the place where the President is institutionally strong (foreign policy). A Congress divided into two houses, a Supreme Court, and the states limit the President dramatically in domestic politics. However, the Constitution and American tradition give the President tremendous power in foreign policy. The President will surely highlight the U.S. withdrawal from Iraq and the winding down of the war in Afghanistan. Another foreign policy matter that may move the oil markets will be his discussion about Iran and the potential impact of U.S., Japanese, and European sanctions on Iranian oil.

Obama’s re-election strategy may be one of opposition to Congress. Essentially, this was Bill Clinton’s strategy in 1996 with a Republican Congress and it worked. Going into opposition against Congress could energize the President’s base, but that base is in the low to mid-40s. By itself, this may not be enough. Instead, over the next 10 months, Obama’s strategy may be to shift from the domestic aspects of the presidency where he is weaker to the stronger part, foreign policy, where a president can generally act decisively without congressional backing.

The critical issue for post-Iraq war foreign policy may be the U.S. relationship with Iran. An often rumored “October” surprise is the idea of attacking Iran’s nuclear facilities. But a precise strike can be messy since it carries the risk of Iranian retaliation in the Strait of Hormuz through which a meaningful percentage of the world’s oil travels. An approach with less chance for global economic disruption is a generalized air campaign against both Iran’s nuclear and military sites. But, in our view, starting a war is a huge risk. Setting aside all other considerations, from a political point of view, it would alienate Obama’s political base, many of whom supported him because he would not undertake the unilateral military moves of his predecessor. This is not intended to imply President Obama would consider starting a war for political ends, but merely to show that even if it were a consideration it is unlikely to be a successful strategy.

However, there is another foreign policy option, one that would appeal both to Obama’s political philosophy and to his political situation: pulling a Nixon. In February 1972, the last year of his first term as he ran for re-election, President Richard Nixon visited China in a grand diplomatic gesture even while Chinese weapons were being used to kill American soldiers in Vietnam. In another interesting parallel that rings with echoes of the themes of Obama’s SOTU address, President Theodore Roosevelt did the same thing with the Soviets in 1941. A diplomatic engagement with Iran would seem to appeal to the President and his political base and rejuvenate some of the energy around a theme that helped him win the election in 2008.

We will be listening to the SOTU for clues as to the President’s foreign policy initiatives. If the President were to pursue this foreign policy choice, it may have the effect of sharply lowering oil prices — and help to stimulate the U.S. economy — as geopolitical risk fades and added supply returns with the potential for a lift of the long-running embargo that has blocked critical parts and equipment needed to ramp up Iranian oil output. While a gesture by no means guarantees a resolution, the markets may welcome news of a potential arrangement with Iran.

LPL Financial Weekly Market Commentary for January 4, 2012

Rose Greene, CFP — Wed, 04 Jan 2012 21:35:34 +0000

Stock Market’s Flat 2011 May Suggest Booming 2012

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

During the last trading day of 2011, volatility drove the S&P 500 down in the final seconds to leave the Index unchanged from where it started the year and the total return at a mere 2%.

There have been four years since WWII when the total return for the S&P 500 was roughly flat. All three of these years that preceded 2011 were followed by strong gains in the following year, averaging 38%.

While the historical pattern suggests that a strong 2012 may follow a flat 2011, our outlook remains for an average gain of about 8 – 12% in 2011

The last trading day of 2011 seemed to be a fitting way to end the year. The S&P 500 Index remained in positive territory for the year until the last seconds of the day when a batch of sell trades produced the quick drop that left it to close at 1,257.60. This left the S&P 500 to end 2011 unchanged from the 1,257.64 closing level of 2010.

The volatility on the final day of 2011 was characteristic of a year in which the daily volatility of the S&P 500 was nearly double the average since WWII. Stocks produced gains early in the year and rose to a three-year high of 1,363.61 at the end of April, up about 9% for the year. Then the Index began a rocky decline that culminated at the beginning of October, at 1099.23, down about 12% for the year, before climbing back to where it began the year. While the Index price was unchanged in 2011, the total return for the S&P 500, which includes dividends received, was a mere 2% [Chart 1].

This reflects a stall in what had been a powerful two-year winning streak for the stock market as it rebounded most of the way back from a closing low of 676.53 to the peak of 1565.15 that preceded the financial crisis.

Does the pattern of performance exhibited by stocks in 2011 bode ill for 2012? Not historically, as the last time we saw a year with similar performance was 1994. Similar to 2011, in 1994:

The S&P 500 was basically unchanged for the year with a total return of 1.32%
Earnings for S&P 500 companies grew at a double-digit rate
Defensive sectors, such as Consumer Staples and Health Care outperformed

While things may have looked bleak in 1994, it turned out to be far from the end of the business cycle. In fact, 1994 turned out to be the set up for the strongest five-year run in history for stocks as valuations soared, starting with a 38% total return in 1995. Recall that as of the end of 1994, the price-to-earnings ratio measured on the past four quarters of earnings, had fallen below average [Chart 2] and was setting up for a surge in valuations in the years ahead.

Moreover, valuations, as measured by the forward price-to-earnings ratio on the consensus forecast for the next four quarters of earnings, had dropped to 12.4 as of the end of 1994. This is a similar level to today’s 11.7.

Looking back further, we can see that in total there have been four years since WWII when the total return for the S&P 500 was basically flat: 1953, 1960, 1994, and 2011. All three of these years that preceded 2011 were followed by strong gains in the following year, averaging 38%.

While the historical pattern suggests that a strong 2012 may follow a flat 2011, our outlook remains for an average gain for the S&P 500 of about 8 – 12% in 2011, as detailed in our 2012 Outlook publication. We see these gains supported by a slight improvement in valuations and mid-to-high single-digit earnings growth as the pessimistic outlook for profits reflected in the markets rise to converge with a slide in the lofty expectations for earnings projected by Wall Street analysts.

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LPL Financial Weekly Market Commentary for November 29, 2011

Rose Greene, CFP — Tue, 29 Nov 2011 19:53:44 +0000

Black Friday Caps a Dark Week for Investors

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

It was a black Friday for investors as the holiday week closed with the S&P 500 turning in its worst performance during the week of Thanksgiving since 1932.

Fear gripped the market that the risk of a default by a major European government that would trigger a financial crisis was rising.

It is likely to take years to resolve the debt problems in Europe; however as with the lingering U.S. subprime mortgage debt and housing problems, merely stabilizing the problem may allow markets and the economy to heal from the damage.

As progress in managing risks and efforts toward fiscal sustainability meets with setbacks and disruptions, expect continued market volatility — but not all of it to the downside as in the past seven trading days.

It was a black Friday for investors as the holiday week closed with the S&P 500 turning in its worst performance during the week of Thanksgiving since 1932. Despite strong retail sales indications and solid readings on U.S. economic growth, worsening sentiment on the European debt problems — combined with a failure of the super committee in the United States to agree on deficit cuts — pulled the S&P 500 down 4.7% adding to the cumulative decline of 7.9% in just the past seven trading days.

U.S. economic data was solid again last week with claims for unemployment benefits falling further below the 400,000 level, home sales rising over 13% year-over-year, and a 12% year-over-year rise in orders for durable goods excluding the volatile transportation (airplane) orders in October. This week’s ISM reading on Thursday and the employment report on Friday will be closely watched. Fourth quarter gross domestic product (GDP) is on pace to top the third quarter’s growth rate.

In addition, retail sales during Thanksgiving weekend climbed 16% as more shoppers hit the stores and spent more money, according to the National Retail Federation, wildly exceeding consensus estimates. Retail sales matter to the stock market mainly because they reflect the health and sentiment of the consumer and investor [Chart 1], but also because they contribute to growth of the economy and corporate profits.

The market knew going into last week it was a long shot that the super committee would produce a deal for the $1 trillion-plus in deficit reduction with which they had been tasked. However, some disappointment over the failure that may have affected markets was that it dimmed the prospects for getting those items passed that have greater near-term consequences for the economy and markets. The real deal Congress must pass before year end is some combination of these expiring programs:

Payroll tax cuts
Unemployment benefits extension
The 100% depreciation of new capital spending for businesses
The annual physician Medicare fix and the AMT fix

Although these extensions are by no means off the table and it is still likely some of these pass in an end-of-year session, the odds that Congress cannot reach any agreement have risen.

The main driver of last week’s market action was the fear among some market participants that the risk was rising of a default by a major European government that would, in turn, trigger the collapse of financial institutions and a crisis throughout Europe and beyond. This potential path echoes the chain reaction that followed the bankruptcy of Lehman Brothers in September 2008 that led to a global financial crisis.

In late October 2011, European policymakers crafted a ground-breaking agreement that addressed recapitalizing the banking system, created an orderly default by Greece, and provided financial buffers against losses on future bond issuance among eurozone members. All of these steps are in an effort to reverse the tide of money that has flowed out of the European sovereign bond market and pushed up borrowing costs. These actions averted a 2008-like financial crisis. However, concerns remain about the outlook for economic growth in Europe and the ability of some countries to meet budget targets. As hurdles to implementation of the debt plan are materializing, bond yields of some European nations have risen to levels that make progress on balancing budgets very difficult. There are eight European countries with yields over 6% [Chart 2]. Last week, Italy saw its 10-year borrowing cost rise above the 7% threshold that forced Greece, Ireland, and Portugal to seek bailouts in 2010.

There are many technical factors driving yields higher, including European bank asset sales as these institutions raise required capital. However, fundamental factors lie at the heart of the rise, particularly for the eight European nations with yields over 6%.

The troubles of Greece, Portugal and Ireland are no secret. These three nations were granted bailouts in 2010 that continue to provide ongoing support. The worst off is Greece, which, despite a landmark debt deal, still faces years of economic decline. The best off is Ireland which has proven itself as the bailout country most loyally implementing austerity and markets are responding. Irish yields have fallen from 13.8% to 9.3% over the past four months and the economy has produced solid economic growth. Fortunately, the bond markets of these nations are relatively small and banks have largely insulated themselves from the impact of a default.
Hungary is part of the European Union and received IMF funding, but does not use the euro and cannot until 2020 at the earliest.
Italy has implemented spending cuts and is running a primary surplus, meaning that the borrowing is to cover their debt costs and not to fund new spending. Italy’s budget deficit is less than 5% of its GDP, lower than France’s 7% and close to Germany’s 4%. However, Italy has over 2 trillion euros in debt totaling about 120% of GDP. In an effort to lower debt, Italy has cut government workers, raised revenue with closing some tax breaks, and sold some government assets. With the recent change in power in the Itailian government, more cuts are on the way.
In some ways, Spain is better positioned than other European countries. It has shown a greater tolerance for cutting spending and last week’s election generated a strong majority for the incoming ruling party which has emphasized further fiscal reform. Fortunately, Spain’s debt-to-GDP is only half that of Italy. On the negative side, its budget deficit is twice Italy’s and its banking sector is perhaps the most damaged in Europe, other than Greece.
While Iceland does not use the euro and is not even a member of the European Union, Iceland suffered a banking collapse in 2008 and required support from the IMF. Iceland has made some progress. Notably, Iceland had its credit rating outlook raised last week by Standard and Poor’s and bond yields have declined to 7% from about 13% at the peak in 2008.
While a bond yield of 6.1% may seem high, Poland’s borrowing costs are in line with the average of the past 10 years and well below recent peaks and therefore likely to remain manageable.

As many European countries (eight), have yields below 3% as above 6%. Although these countries do not share the same fiscal position, they are not immune to the economic impact of contagion in the region. The troubles with Greece, Italy, and Spain lie at the heart of the problem for all of Europe. The long-term success of rescue efforts is dependent upon European nations taking additional steps to adhere to their plans for achieving financial stability and deficit reduction. It is no coincidence all of these three countries have seen a change to their governments in 2011 to those willing to take more aggressive actions.

Lack of enforcement of budget rules is a big part of what drove Europe to the current state. Going forward, the European policymakers want to ensure important steps are taken before extending additional support to halt the slide in the markets. While it will take years to resolve the debt problems in Europe, with the lingering subprime mortgage debt and housing problems in the United States, merely stabilizing the problem can allow markets and the economy to heal from the damage. We expect the passage of the difficult, but necessary, reforms among the troubled nations, during the coming weeks and months.

As progress in managing risks and efforts toward fiscal sustainability meet with setbacks and disruptions, expect continued market volatility — but not all of it to the downside as in the past seven trading days. Hopefully, as we leave black Friday and the month of November behind the market has a brighter start to December.

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LPL Financial Weekly Market Commentary for November 15, 2011

Rose Greene, CFP — Tue, 15 Nov 2011 22:05:22 +0000

The Best Year-End Strategy May be to Invest by the Book

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

All of the time-worn stock market trading axioms based on the calendar actually were worth following this year, including the “January effect”, “sell in May and go away” and October the “bear killer” month.

This textbook pattern of calendar-driven performance by the stock market may mean that the best year-end strategy is to invest by the book as a “Santa Claus rally” unfolds in December.

It has been a textbook year. That is, if your textbook is the Stock Trader’s Almanac. The old stock market chestnut “sell in May and go away” proved to be good advice this year. But that was not the only old adage of Wall Street traders that worked in 2011 — they all worked.

This has been the year of the stock market cliché in that all of the time-worn axioms based on the calendar actually were worth following this year:

The “January effect” (the market tends to rise in January attributed to individual investors putting money to work after taking tax losses in December) worked this year as the S&P 500 posted a 2.3% gain in January. The “January barometer” (stock gains in January often lead to a gain for the year) and the overlapping “first five days” indicator (stocks rising during the first five days of the year indicate a high probability for a gain for the year) have both proven accurate, so far.
“Sell in May and go away” (suggests investors sell and avoid the summer months) worked with stocks peaking for the year on April 29.
October, the “bear killer” month (stock market downturns famously end and reverse in the month of October), ended the 19% peak-to-trough stock market decline with stocks bottoming for the year on October 3.

If this “year of the market axiom” pattern continues, what comes next? Perhaps a “Santa Claus rally” is in store for December. Markets must still move past the uncertainty of November that includes key policy events:

Government transitions in Europe.
Action by Congress to avoid a government shutdown.
The Super Committee proposals to find $1.5 trillion in deficit reduction measures.

But then a year-end “Santa Claus rally” may cap off a volatile year of modest single-digit returns for stock market investors.

What may be the trigger for the textbook year-end rise in the market known as a “Santa Claus rally?”

A rebound in investor sentiment as Europe takes long overdue actions to avoid a financial crisis.
Improvement in the job market as foreshadowed by the recent decline in initial jobless claims below the 400,000 level in recent weeks.
The holiday shopping season surprises by exceeding retail sales estimates, as it did last year.

This textbook pattern of calendar-driven performance by the stock market may mean that the best year-end strategy is to invest by the book.

To download a complete copy of the commentary click here