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Fighting the Fed was never a winning strategy, and the exercise is turning out to be even more difficult in the current environment. Markets have been steadily moving up lately and remain within striking distance of all-time highs set in the fall of 2007, roughly a year prior to the Lehman Brothers collapse.
Some may disagree with my crediting the Fed for the market gains, citing recent a turn in economic data, the not-so-shabby earnings picture and a less worrisome international backdrop. All of those are reasonable points. But we have to acknowledge that interest rates would be a lot less supportive if the Fed (and the European Central Bank, Bank of England, and now the Bank of Japan) wasn't deploying its enormous balance sheets to keep them low.
The Fed balance sheet recently crossed the $3 trillion mark, more than triple its size when the stock market last peaked in the fall of 2007. At its current pace, it is reasonable to expect that it will be close to $4 trillion by the end of this year. The stock market loves liquidity (who doesn't?) and the Fed seems determined to keep the spigots open for quite some time to come.
Is There No Basis for the Rally?
There are no doubt grounds for optimism - the economic picture is looking healthy enough and policy makers have been able to avoid a few self-inflicted wounds ('Fiscal Cliff', debt ceiling). Some may even argue that recent price action creates a justification of its own. I can appreciate the logic of chasing momentum for active traders, but it may be of limited value to long-term investors who need to sift hype from reality.
But the validity of price momentum aside, some optimism on the economic front is justified, particularly with respect to the U.S. and China. The domestic housing scene is clearly looking up, notwithstanding today's weak Pending Home Sales report. The positive beneficial effects of a sustained housing recovery will get a further boost if the trend of the last two weekly Jobless Claims reports turn out to be for real.
Beyond U.S. shores, the outlook for China has clearly changed, with nobody talking about the much-dreaded 'hard landing' scenario any more. By some measures even the situation in Europe may not be as grim.
This Week's Economic Reports
We have a very busy economic calendar this week, with the January non-farm payroll report on Friday, the first look at fourth quarter GDP on Wednesday and the manufacturing ISM report also on Friday. We have the FOMC meeting this week as well, with the post meeting statement coming out Wednesday afternoon.
All of these are market moving reports, but the jobs report will be the most critical. The expectation is for gains of around 160K in January, but, given the sharp drop in initial Jobless Claims the last two weeks, everyone will be hoping for a big positive surprise. We got a strong labor market start in each of the last two years, but the momentum couldn't be sustained later in the year. It is reasonable, therefore, to be a little skeptical if we get a positive jobs report this Friday.
The GDP report is expected to show a sharply lower growth pace of about 1%, but the slowdown is believed to be largely due to temporary factors like Sandy, low defense department spending and a low inventory build. Overall, the consensus view is that GDP growth remains weak in the first half of the year, but materially improves in the back half that carries into next year. It is hard to square this growth outlook with the expiration of the payroll tax cut due to the Fiscal Cliff deal and potential spending cuts due to the budget sequester. But this is what current market prices are reflecting a slower economy in the first half and a growth ramp-up in the second half.
Are Earnings Really That Good?
Investors are finding enough reassuring data in the ongoing fourth quarter reporting season to sustain the positive stock market momentum. A big part of the earnings outperformance is due to lowered expectations that made it easier for companies to come out ahead.
Just like the earnings beat from Yahoo (YHOO) after the close today, we have positive earnings surprises from 63.9% of the 155 S&P 500 companies that have reported results as of this morning. Unlike the third quarter, the revenue picture doesn't look that bad either, with 60% of the companies coming ahead of revenue expectations. This is a better performance than what these same companies reported in the third quarter and broadly in-line with results over the past year.
But to say that the market has solely become satisfied due to the ratio and magnitude of these beats would be untrue. Company guidance has been favorable as well, particularly relative to what we heard from management teams in the third quarter. Companies are not raising guidance, but neither are they lowering them by and large. And that helps investors gain confidence in estimates for 2013, which many of us had been raising doubts over for quite some time.
The overall positive tone in the market, however, shouldn't hide the fact that earnings growth has effectively flat lined. Total earnings for the 155 S&P 500 companies that have already reported are up only +0.3% (down -6.3% excluding the Finance sector). The composite earnings growth rate, combining the results of the 155 that have come out with the 345 still to come, is for only +0.4% growth. The final growth tally for Q4 will most likely come in at around +2%.
This would mean that total earnings were up about +3% in 2012. But expectations for 2013 suggest the growth pace picking up, particularly in the back half of the year and carrying into 2014. This reflects the second-half recovery narrative imbedded in current GDP growth estimates referred to earlier. I have been skeptical of these growth expectations for a while, but the market has been shrugging the growing evidence thus far.
Putting It All Together
There are grounds for optimism, but they don't justify stocks going back to all-time high levels. That said, I remain an advocate of remaining fully invested and caution against the allure of fancy market timing strategies. There is nothing wrong with market timing, but it's not for everyone. My view implies that you lighten up on economically sensitive sectors/industries and expose yourself to industries/companies that don't rely on above-trend economic growth to generate outperformance. You will likely miss out on some upside potential should the optimistic outlook reflected in current market prices turn out be true. But you will be saving yourself from a lot of trouble in every other potential outcome.
Focus List Update
We made no changes to the Focus List this week, but I do want to highlight a key feature of the portfolio to explain how you can increase your defensive posture while remaining fully invested.
The oil and gas industry, like all other commodity producers, is an economically sensitive space and will likely be under pressure in times of economic distress. But as we have done in the Focus List, you can have exposure to segments of the oil patch that are relatively less exposed.
Case in point, our master limited partnership (MLP) holdings, six in total, that give us industry exposure in a safe and income oriented way. MLPs like Enterprise Products (EPD - Analyst Report) and ONEOK Partners (OKS - Analyst Report) are yield-oriented tax-advantaged investments. So, you should have a good sense of how beneficial or otherwise they will be to your investment portfolio. But overall, they are excellent long-term holdings.
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