Dion Money Management Blog   Money Management for Retirees and Their Families

Stocks seesawed their way through the week, as oil prices moved higher and public finance issues dominated the news cycle. So far the slide this month has been marginal after a multi-month advance allowed the S&P 500 to double from its 2009 lows and brought the index firmly above its long-term moving averages. While the number of individual stocks above their own 50-day moving averages has begun to wane, the current 62 percent is above the 58 percent level seen during November’s slide, showing that market breadth is still healthy.

Investors continued to assess the political turmoil in the Middle East and its potential to spread to other critical oil-producing nations, such as Saudi Arabia. While analysts acknowledge that oil prices could spike to $120 per barrel given the uncertainty of the outcome, today’s $100 level is a likely year-end target once the current disruptions are resolved. Although it would probably require a price of $140 per barrel to spur a possible recession in personal consumption, even oil at $110 is high enough to weigh on equity markets, which translates to a 40 percent year-over-year increase. So although current prices are a concern, they are still below some critical thresholds and much lower than previous spikes in the past 10 years, or during the 1970s.

Federal Reserve Chairman Ben Bernanke acknowledged these commodity pressures during his semiannual monetary policy testimony before Congress this week, stating that higher prices would represent a threat to economic growth and price stability if sustained or inflation expectations became “unanchored.” However, he also noted that recent monetary policy decisions have had a “beneficial effect” on the recovery, judging from the stock market’s response and the improved economic outlook. Bernanke also acknowledged that the recovery underway in consumer and business spending appears self-sustaining, even if a longer period of job creation is still necessary to reaffirm the improving employment trends.

Those trends were reaffirmed on Friday when the latest employment report from the Bureau of Labor Statistics (BLS) was released. The unemployment rate in February dropped to 8.9 percent even as the labor force grew. The private payroll number increased by 220,000, although the overall payroll data was less due to the continued drop in government jobs at the state and local level. Government is expected to act as an ongoing drag on employment levels and overall growth in 2011 as states face budget deficits of $130 billion.

Nevertheless, the private payroll results reflect improving labor conditions, which are corroborated by regional employment indices, as well as the ISM and ADP surveys. The ADP data, also out this week, showed an acceleration of payroll growth, particularly as it relates to small- and mid-sized companies, which are slowly reflected in the BLS data. Jobless claims also dropped this week, bringing the four-week average down to 389,000.

Meanwhile, both the manufacturing and nonmanufacturing ISM indices gained ground in February. The employment indices of each report were positive and suggest a faster pace of employment growth in the months ahead. The reports also indicate that an acceleration in gross domestic product (GDP) is underway due to a large rise in the production index and higher durable goods orders.

Disclaimer

Political tension and violence in the Middle East and the subsequent spike in oil prices were too much for the stock market this week. After a long spell of lower volatility, stocks ended a nearly uninterrupted multi-month advance by sliding almost three percent before gaining ground on Friday. Market jitters were calmed when news came that Saudi Arabia would increase production and make up for any lost capacity in Libya.

Higher oil prices are not always a threat to the stock market, but they do impact gross domestic product (GDP). Large-scale macroeconomic models, such as those maintained by the Federal Reserve, suggest that a sustained price increase of $10 per barrel for one year can reduce global GDP by as much as 0.3 to 0.5 percentage points moving forward. However, as we witnessed from 2002 to 2007, stocks can continue their ascent even when faced with higher input costs such as the cost of oil. This is because energy and materials stocks do well as these companies charge more for their products, and industrials can do well if strong demand from commodity producers or other industrializing nations is enough to outweigh the impact on overall demand. Meanwhile, technology and financial companies can continue to thrive due to limited exposure to rising commodity prices.

Although higher energy prices are not likely to be an obstacle to economic growth at present, the challenges may come later in the form of lower margins in resource-sensitive sectors such as consumer staples, but right now capacity utilization and minimal wage pressures should help companies absorb higher costs. If inflation were to become more broad based at home or abroad, either discretionary consumption might decline or monetary tightening could become a reality that would slow economic growth. Right now, investors are more concerned with political tensions spreading to other oil-producing nations, which could impact supplies further. While it is difficult to know the final impact on prices, OPECs spare capacity of 8.4 million barrels per day is enough to compensate for much of the lost capacity in nations such as Libya or Algeria that produce less than 2 million barrels per day.

Long-term and experienced investors will look past the uncertainty brewing abroad and keep a keen eye on the fundamentals in the U.S., much of Europe, and certain emerging markets, where economic data has been robust and momentum is strong. Upcoming data is likely to provide support to reasonable equity valuations, and shareholder friendly activity is spreading. Although uncertainty can spur a correction after a swift upward climb since the summer, a shift in investment strategy is not yet warranted. Fear of the unknown should remind us that diversification is a powerful tool on the road to prosperity.

The stock market nudged itself higher again this week, keeping the month of February solidly in positive territory. If we can hold these gains through month’s end, stocks will have been up five out of the past six months. November was the last time that investors withstood more than a three percent sell-off, yet even that month registered a less than one percent loss.

Long-term winning streaks such as this are rare. Three-month stretches occur less than 15 percent of the time, and longer streaks of six months or more occur less than four percent of the time. So as investment surveys begin to show signs of waning bullish sentiment in anticipation of a pullback, it is appropriate to consider whether caution is warranted after a sustained advance or the potential end of a winning streak. Yet, during bull market cycles, stocks can register a disproportionate share of gains after a streak has finished. In fact, the longer the streak, the better the subsequent market performance, although variances are widespread.

Therefore, in a month when the S&P 500 also realized an important milestone by doubling itself from the previous bear-market low, it is fair to ask what type of momentum we can expect moving forward. After all, this milestone itself has been followed with mixed results, with bull markets either ending shortly or gaining an average of 50 percent – and a median of 16 percent – more in the 7 to 16 months that follow. Rather than play a game of probability, however, it is more important to analyze the reasons behind the most recent advance. These include strong economic growth and rising corporate profitability, as well as reasonable valuations and poor investment alternatives offering low yields.

Since 2007, stocks have been highly correlated with “economic surprises”, or the ability of economic and corporate growth news to beat consensus forecasts or market expectations. We have certainly witnessed one such stretch of positive surprises since the economic slowdown experienced over the course of this past summer. Yet even if the momentum of this positive news subsides, the global economic recovery is robust, and we are likely to reach higher levels in the months ahead. This week, the Philadelphia Fed manufacturing survey surged to levels not seen since 2004, and the Empire State manufacturing survey also gained ground, implying a strengthening of output that confirms the recently released ISM report.

The lack of compelling investment alternatives also bodes well for a healthy stock market. Even as interest rates begin to rise, they will likely remain unappealing in the short term until credit spreads widen and offer more reward per unit of risk. And for those investors that fear inflation or rising yields as detriments to economic growth, the headwinds are not yet unmanageable. In fact, equity markets and bond yields tend to rise in tandem whenever the 10-year Treasury note is yielding less than 4.5 percent. Today’s roughly 3.6 percent yield provides a 25 percent cushion, and right now rising rates actually imply a pickup in growth ahead.

Good economic and corporate earnings reports have kept the stock market on track for yet another week. The Dow Jones Industrial Average logged eight straight days of positive returns before turning down marginally on Thursday, and the rally since August lows has now returned more than 20 percent. The S&P 500 also continued its trek to post-recovery highs. More stocks hit 52-week highs this week than at any time since early December, and greater than 80 percent of index firms are trading above their 50-day moving averages.

It is the U.S. stock market that has garnered the most attention so far this year, as inflation concerns give investors a reason to sell investments in the traditionally volatile emerging markets. The concern there is that governments may not move quickly enough to quell overheating economies, leaving monetary policy tightening as the principle method to combat inflation. Similar concerns induced profit taking in early 2010.

Meanwhile, I have discussed several factors converging to boost sentiment toward U.S. stocks. First, the extraordinary amount of additional liquidity announced and carried out by the Federal Reserve is supporting the financial system in different ways. Keeping interest rates low helps small and large-businesses alike, but corporations can capitalize on these conditions by increasing expenditures, buying back stock, and conducting mergers and acquisitions.

Also, the expectations that the economy is on firmer ground has increased small business optimism and consumer confidence. This week the NFIB small business optimism index rose to 94.1 in January, which is up from the 80s in the first half of 2010. The latest survey included improved expectations for better credit conditions, as well as the outlook for sales and the economy in the months ahead. The University of Michigan consumer sentiment index also rose in this week’s report, reaching 75.1 in early February, which is up from the low 70s in the first half of 2010. Although there were gains in the index’s assessment of current conditions, which reflects the fact that real consumer spending climbed to a 4.4 percent pace in the fourth quarter, the expectations component declined in the most recent reading. Nevertheless, the evidence is mounting that the economic recovery is on firm ground, and this will provide a supportive backdrop for U.S. equities.

Another factor helping to boost sentiment is strong corporate earnings results. Now that more than 80 percent of the S&P 500 market capitalization has reported, revenues have climbed a strong 9.3 percent year over year, with technology and energy firms showing the best gains in operating earnings from quarter to quarter. Moreover, earnings look set to grow again in 2011. The amount of positive surprises that are above consensus expectations continue to outpace negative announcements, in spite of margin headwinds such as rising commodity costs and tougher regulation.

Disclaimer

The market’s impressive run since August continued for another month with the S&P 500 adding another 2.3 percent in January. While some analysts may wonder if the market is becoming too frothy or if investors are getting ahead of themselves, the market’s success has been tied to incoming data that depicts better fundamentals. From economic stats to corporate earnings, investors are receiving clear signs of an economy gaining strength, and the market action reflects this sentiment.

After last week’s solid report on third quarter gross domestic product (GDP), which showed a strong surge in final demand that brought the indicator well into positive territory, all eyes turned to this week’s manufacturing and employment reports as a gauge of the current quarter. On Tuesday, we learned that the manufacturing ISM index climbed to 60.8 in January, showing that growth was still rising at the outset of 2011. The components most indicative of faster growth, such as employment, new orders, and production, all posted gains.

On Thursday, factory orders were higher than expected, showing an upward revision of durable goods orders, and the nonmanufacturing ISM report jumped to the highest levels since 2005. Putting the two ISM reports together provides a better picture of the entire economy. At 59.6, the all-economy index is higher than at any point since August 2005 and suggests an acceleration of GDP growth in the current quarter to a 4.2 percent annual rate. Although oil prices are rising again, the impact at this point should be minimal. According to the Federal Reserve’s econometric model, every $10 increase in price of oil per barrel results in a 0.2 percent reduction in GDP per annum over a two-year period. Moreover, other factors may compensate for the decline, such as an increase in inventory investment, which had been low toward the end of 2010.

The recent spike in oil prices is tied to the political turmoil in the Middle East. Because I believe the conflict in Egypt is likely to be resolved internally and without greater escalation, I took the opportunity to sell our positions in ICON Energy (ICENX), which we have held since last June, for sizeable gains relative to the S&P 500. I have used the proceeds to buy ICON Industrials (ICTRX), which is exhibiting strong momentum year to date. The industrials sector, along with information technology, healthcare, and energy, are producing positive earnings results. After 73 percent of the S&P 500 market capitalization have reported their fourth quarter results, the ratio of positive versus negative surprises for industrials is 2 to 1. The technology sector, to which we also have overweight exposure, is performing the best due to greater insulation from materials costs and regulatory pressure.

Finally, this week brought an update of employment trends. The Bureau of Labor Statistics reported a drop in the unemployment level to 9.0 percent in January, with only a modest gain of 36,000 in private payrolls. Although the report showed a sizeable drop in the labor force, the Labor Commissioner stated that changes were made to their population assumptions, so in fact, the labor force remained unchanged. Poor weather undoubtedly affected hiring of construction, transport, and temporary workers, so next month’s report should see a resumption of payroll growth.

Although the rally in stocks took new flight this week, its wings were clipped on Friday when the report for gross domestic product (GDP) showed less growth in the fourth quarter than expected and as unrest spread in Egypt ahead of the weekend. Still, real GDP accelerated to an annual rate of 3.2 percent, which is higher than the third quarter’s 2.6 percent annual pace. The composition of the report was strong, exhibiting higher consumption and business investment that was enough to make up for a decline in government spending. The Federal Reserve is watching private demand as an indicator that the economic recovery is on track; it was climbing at a 4.5 percent annual rate over the second half of last year.

The Federal Open Market Committee (FOMC) met earlier this week and issued its customary statement, committing to its purchase of U.S. Treasury debt and to keeping interest rates at record low levels near zero. Although there had been a reduction in the unemployment level since the member’s last met, the statement made note of the insufficient improvement in labor market conditions, which reflects the need to see gains in household employment rather than a reduction in the labor force. The Fed also noted that inflation measures were stable in spite of rising commodity prices.

In spite of the Federal Reserve’s assessment of the labor market, measures of consumer confidence released this week were higher, corroborating other measures released earlier this month. The Conference Board index rose to 60.6 in January, and the University of Michigan survey bounced back from softness in December. In particular, the former exhibited a stronger assessment of current conditions and the labor market, while the latter showed improvements in the expectations component and the outlook for government policies.

The price of gold has retreated from the December highs, ending a period of seasonal strength. This happens to coincide with declining fears over economic stagnation and European debt woes, so the risk premium may be declining as well. Although investors often look to the movements of the U.S. dollar to explain gold’s fluctuations, sovereign risk has been largely responsible for driving gold to new heights in recent years. This was particularly true during the crises in Europe, and the correlation with the dollar has largely broken down as of late. But I believe it is too early to put the stress over eurozone debt behind us. Although rescue measures have effectively prevented defaults in the short run, a mechanism for the long run remains lacking and will rely on bondholder participation. Therefore, bond defaults or restructurings will occur, and the noise and fear surrounding this will most likely keep gold aloft for some time to come.

Please note that according to Fidelity, the Tax Relief, Unemployment Compensation Reauthorization, and Job Creation Act of 2010 extended the Qualified Charitable Distributions (QCDs) provisions for 2010 and 2011, allowing individuals age 70½ or older to exclude from gross income up to $100,000 paid directly from their individual retirement accounts (IRAs), excluding SEP and SIMPLE IRAs, to a qualified charity. The excluded amount can be used to satisfy any Required Minimum Distributions (RMDs) that individuals must otherwise receive from their IRAs for 2010 and 2011. Individuals have until January 31 to make a contribution for 2010.

Disclaimer

The momentum that carried stocks robustly higher in December and early January came under a little bit of pressure this week. Although the Dow Jones Industrial Average should finish positive for the four-day trading week, the S&P 500 is struggling to recapture lost ground and may finish down for the first week in eight. On Tuesday, it suffered its first one-day loss of more than 1 percent since Thanksgiving. That capped a 37-day streak without such a loss, which is the longest period since May 2007. This is reminiscent of 2006, when volatility was greatly reduced and such losses were rarer still.

All eyes are on January because of the so-called January Indicator, which often reveals that the trend for the year is established in the first five days of trading, as well as the first month of the year. Although the results are more impressive for the first five days, which were positive in 2011, a positive January also bodes well for the upward trend.

Speaking of cyclical tendencies like this, there is also a presidential cycle that is often quite accurate. Since 1962, the period following each midterm election through the subsequent year has been positive for the S&P 500 by an average of 21 percent. This tendency for the market to rise during the third year of a president’s term is tied to an administration’s efforts to boost the economy ahead of its own party’s reelection efforts, as well as a relief rally that can ensue once the outcome of the midterm election is known.

Right now the economy is on better footing and we can anticipate that the recovery remains on a slow but sustainable path. Consumer spending has surprised to the upside as labor market conditions have stabilized and begin to show tentative signs of improvement. These are necessary preconditions to creating a reinforcing feedback loop of income gains, more spending, and higher employment levels as corporations anticipate better opportunities ahead.

And corporations remain in surprisingly fine health. Earnings have been robust for several quarters as firms cut costs during the recession in order to increase their margins and profitability. Although earnings growth surged in 2010 to nearly 40 percent, growth should be a more moderate 10 to 15 percent this year. After just 21 percent of the S&P 500 market capitalization has reported on the fourth quarter results, 64 percent have beaten analysts’ consensus by nearly 2 percent. Revenues should be strong in cyclical sectors such as technology, but growth will also moderate in 2011.

Manufacturing data released this week showed that output is gaining momentum in January. The current activity index for the Empire State survey was stronger than December; the indices of new orders, shipments, and employment were higher. The same was true for the Philadelphia Fed survey, in which the growth-related details of the report were also stronger. Meanwhile, the index of leading economic indicators (LEI) surged 1.0 percent in December. The LEI has been positive for all but one month since the recovery began in July 2009.

Disclaimer

When I talk about periods of seasonal strength, the past four to five months certainly qualify. December, and now January, have carried forth the momentum established in early fall when the economy began to show new signs of life. You would have to look back as far as 1990 to find a December as robust as the one we just experienced—the S&P 500 remained more than one standard deviation above its 50-day moving average for the entire month. There have only been seven occurrences of similar strength since 1928, and the majority of these resulted in a strong January as well.

Not only has the S&P 500 ticked upward for seven straight weeks now, but it has not fallen below its 10-day moving average in 30 consecutive trading days. Both of these events are unprecedented. Furthermore the Dow Jones Industrial Average has not had a down day of 1 percent since before Thanksgiving. According to Bespoke Investment Group, Monday’s 0.32 percent decline capped a fairly remarkable 30-day run in which no decline was greater than one-third of one percent. This has not occurred since 1965.

This steady march higher has left investors and analysts feeling rather ebullient. A sentiment survey conducted by Investors Intelligence has shown advisor bullishness, in particular, to be at multi-month highs. At times this is a warning signal, yet the market has plodded higher thanks to the positive mix of fiscal and monetary stimulus, strong economic data, and high expectations for the current earnings season now underway.

Analysts have revised higher their earnings estimates, as economists have increased their projections for gross domestic product (GDP). The economy is accelerating, in part, due to the extension of the Bush-era tax rates and the surprise additions of payroll tax cuts and extended unemployment benefits. These changes could add another 0.5 percent to 2011 GDP and another $3 to S&P 500 earnings per share (EPS) estimates, bringing total EPS projections to $96 per share, which is close to the highs seen before the financial crisis. Meanwhile, price-to-earnings ratios remain low and are expected to range between 12 and 14 through 2012.

After last week’s disappointing payroll number, this week brought another rise in initial claims. The market absorbed the data with ease, perhaps because this period is ripe with seasonal fluctuations that are difficult to predict. Moving forward, the snow storms affecting many parts of the country will also create a downward bias in future reports. It may shave as much as 50,000 from next month’s payroll number as well. At the same time, a gauge of small-business optimism showed employers less concerned with government regulations and taxes and more likely to hire in the months ahead.

Disclaimer

The stock market has meandered its way to a marginal gain so far this week. After a rapid start to December sent some of the broader indices to new 2010 highs, it is not surprising to see a pause, especially as governments around the world negotiate monetary and fiscal policies to keep the global economic recovery on track.

Here in the U.S., Congress passed an $858 billion bill that extends the Bush-era tax cuts, which were due to expire at the end of this year. The bill provides a two-year extension of those lower tax rates for all income brackets, as well as payroll tax credit and an extension of unemployment benefits. This signals a return to fiscal stimulus, which will combine with recent efforts by the Federal Reserve to spur employment and economic activity and to keep inflation rates from falling. In Europe, leaders of the European Union agreed to create a permanent financial safety net by 2013 in order to address future crises. Details on that framework still need to be ironed out, however, and leaders must still address short-term issues likely to plague the bond markets in 2011.

More important, economic growth remains on track and investors are more confident as the fundamentals continue to improve in December. Even in light of a downbeat private payrolls report, other employment indicators such as initial claims have been trending in the right direction; this week the jobless claims fell again to support the downward trend. Meanwhile, production data has provided evidence that the economy is on solid ground. The third-quarter GDP number was revised upward to an annualized 2.5 percent, with a stronger composition of growth in domestic demand and final sales. This week’s manufacturing surveys exhibited a rebound in the current activity indices.

Recent sentiment readings have also been rising. Both the Conference Board Consumer Confidence Index and the University of Michigan Consumer Sentiment Index showed gains. The November election results and early retail promotions have boosted confidence. In terms of the business outlook, the ISM semiannual forecast shows that businesses expect a broadening recovery.

Even the sell-off in bonds must be seen for what it is: a vote of confidence in economic recovery and the prospect for better stock returns rather than jitters about inflation or fiscal discipline. If investors were truly worried about the fiscal health of the U.S., then stocks and other risky assets would be declining as well. I will continue to monitor the bond market for signs that investor demand is changing for the long term and will react by limiting our fixed-income duration exposure. Right now, investors are increasing their stock exposure in anticipation of continued earnings growth or a re-rating of future risks.

As 2010 draws to a close I would like to remind our senior clients over 70.5 to take their minimum required distributions (MRDs) before the end of December. And with the approach of the New Year, I would like to remind eligible clients to put their 2011 IRA contributions to work as early as possible. You will find a postage-paid envelope and deposit slip in this month’s client letter, which I will mail next month. Please note that there will not be any weekly commentary next Friday due to the Christmas holiday. I would like to wish everyone a peaceful and joyous holiday season.

Disclaimer

If the market typically “gets it right,” then there is a good chance that last Friday’s employment report will either be revised upward or prove to be an aberration from the positive trend seen in other reports. Given the steady stream of improving data from other areas of the economy, the Bureau of Labor’s report was surprisingly weak. Nevertheless, the market refused to relinquish any of its hard fought gains and is off to a fast start in early December.

Even though the entire report disappointed, the worst element of this important growth barometer was the payroll number. Nonfarm payrolls gained an anemic 39,000 last month, which was considerably less than both the 150,000 forecast and the revised 171,000 from the prior month’s report. The private payroll component, which had been the silver lining for many months while the government laid off its census workers, also disappointed with only a 50,000 increase, which was less than a third of the projected number. Furthermore, the unemployment rate moved up two ticks to 9.8 percent, putting it back to the highest level since May. But his week, initial jobless claims fell, keeping the four-week average in a downward trend and providing some evidence that components of the labor market are improving.

Disclaimer

The true silver lining of the report may be its affect on Washington policymakers. Not only will it help the Federal Reserve fend off its critics and allow it to execute further quantitative easing, the poor results may have spurred politicians to agree on the hotly debated extension of Bush-era tax credits. The theory seems to be that if investors can count on the Fed to follow through with its additional easing of monetary policy, as well as the current tax rates remaining in place—even for small business owners who will do the bulk of the hiring—then they are likely to respond by bidding up share prices beyond their 2010 highs. And investors answered the call this week by pushing the S&P 500 and Nasdaq to new heights once a deal was struck on the tax package. Although there is still work to be done, the deal could add 0.5 percentage points to gross domestic product (GDP) in 2011 if passed in its current form.

Part of the reason the market remained resilient in the face of the somber employment news is that other data have provided evidence that the economy is on solid ground. The third-quarter GDP number was revised upward to an annualized 2.5 percent, with a stronger composition of growth in domestic demand and final sales. Recent manufacturing data have also been solid, helping to put fears of a double-dip recession to rest for the time being.

Although poor employment results tend to weigh on the consumer’s outlook, recent sentiment readings have been rising. After last week’s Conference Board consumer confidence index jumped to 54.1 in November, this week’s reading of the University of Michigan Consumer Sentiment also showed gains. The November election results and early retail promotions have boosted confidence, even though a drawn-out debate of tax policy could cause some deterioration.