Don’s Outlook 7/15/2011
The late-June rally, which brought stocks back toward 2011 highs, lost momentum this week. Even though that rally had been broad, pulling all sectors along with it, cyclical stocks had seen the largest rebounds. Some of those gains were reversed this week when those sectors sold off the most. The pattern this week seemed to be one of intraday highs giving way to bouts of weakness and falls of more than 1 percent. Whenever this has occurred over the past two decades, the market has posted better than average returns in the weeks and months ahead according to Bespoke research. Therefore, we still have a good chance of seeing strength return to the market in the short term.
It is not uncommon to see sectors converge at this stage of the business cycle. As the profit recovery has matured, market returns can moderate and leadership can change. Investors will often seek out high-quality stocks that may have attractive valuations and sustainable dividend policies, offering higher returns on equity. This is especially true if earnings growth begins to wane, when there is a more balanced performance between defensive and cyclical sectors.
The question is whether we have finally reached the stage at which earnings growth will moderate. Earnings season is underway, and the major companies that have reported so far are reporting results that are in line or better-than-expected. The expectations are that continued momentum in manufacturing and ongoing strength in emerging markets will be underlying themes. Even though lower credit costs for banks is considered positive, a high-profile write-down by Bank of America has weighed on the financial sector. As always, overall guidance is expected to be cautious in this post-crisis environment.
Most economists and analysts were focused on “Fed speak” this week, including the semiannual testimony before Congress by the Federal Reserve chairman, as well as the release of the June Federal Open Market Committee (FOMC) minutes. Released on Tuesday, the minutes revealed that committee members maintained a strong emphasis on inflation, especially by those who would advocate for additional monetary policy accommodation if the threat of deflation returned. The FOMC remains concerned that a slowdown in manufacturing would be broad based.
However, the most recent economic data released this week offered a fresh perspective on those concerns. Both the consumer price index (CPI) and the produce price index (PPI) illustrated that inflation was alive and well. Even though the CPI fell, core prices were higher and the year-over-year core measure climbed to 2.5 percent from just 0.8 percent last December. The core PPI also escalated, pushing the annual pace to 2.4 percent, with much of the change coming in the past six months. This pressure in core prices will make it harder for the Fed to engage in the same type of monetary easing.
Nevertheless, Fed Chairman Ben Bernanke did more explicitly mention the possibility of additional quantitative easing during his live testimony before Congress on Wednesday. Stocks rallied on the news, and bond prices fell. The comments stem from his outlook that any persistent economic weakness or deflationary risks would call for an additional response, which may or may not include direct security purchases. What the market has overlooked, however, are his previous comments on Fed research showing the limited effects of quantitative easing in terms of job growth, perhaps because it is viewed as supportive of equity prices.
