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Market Analysis

There has been no shortage of skeptics of the market's recent momentum, myself included. But Mr. Market keeps powering higher, getting close to its all-time high point in October 2007. The uptrend appears to be so well entrenched that nothing can derail it. The Fiscal Cliff drama went to the wire, but Mr. Market remained essentially unruffled throughout December. And the devil-may-care attitude seems to be the only explanation for the upcoming budget sequester – now less than two weeks away.

As such, the answer to the question in the title is: why not? Yes, the rally could continue over the next few days and take us above previous highs.

The market's very near-term trajectory may be getting clearer. But that doesn't mean it has long-term staying power.

It's one thing to acknowledge the very near-term trajectory of this Fed-inspired rally, and an altogether different issue to make sense of it all. It doesn't make a lot of sense, at least to me. The level of economic and corporate earnings growth implied by the rally indicates significant improvement from what we have seen in recent quarters.

What's Driving the Optimism?

Some of the optimism definitely has a basis, with favorable developments both in the U.S. and abroad. The negative fourth quarter GDP report notwithstanding, the overall tone of recent U.S. economic data has been positive or neutral. Manufacturing seems to be improving after remaining soft for most of 2012. The labor market is steadily healing, which is helping strengthen household buying power. But the labor market improvement is not fast enough to threaten the Fed's money spigot, which should firmly remain in place for quite some time. And then we have momentum on the housing front and its positive knock-on effects on confidence and other areas of the economy.

Beyond U.S. shores, Europe remains stable thanks to actions from the European Central Bank under Mario Draghi. Borrowing costs for Spain and Italy, two major at-risk countries, remain at reasonable levels even though they have crept up a bit in recent days. The region's economy is in recession, but the outlook for Germany remains favorable, which could potentially have beneficial effects on the rest of the region.

The Chinese economy appears to have turned the corner as well, with that country's industrial and manufacturing sectors showing renewed signs of health. China is not out of the woods yet, as many companies cited in their fourth quarter earnings calls, but the situation is better than what it was last year.

A Case of Market Exuberance

Some level of optimism about the big picture situation is warranted, but what we are witnessing instead is on the exuberant side.

This is particularly so with respect to the outlook for the U.S. and global economy. On the home front, the expectation is that the U.S. economy muddles through the first half of the year, but GDP growth ramps up close to 3% in the second half and improves even further in 2014. This is despite the fact that, irrespective of what happens to the sequester, some level of fiscal austerity has to get underway in the U.S. this year.

These GDP growth expectations then show up in estimates for earnings growth this year and next. Estimates for the first half of the year have started coming down lately, but full-year 2013 earnings growth remains significantly above what we actually got in 2012. And next year is even better, with earnings expected to grow in double digits.

It is hard to envision earnings growing at a high single-digit rate this year and by double digits next year, particularly with revenue gains hard to come by and margins already topped out. The growing resort to mergers and acquisitions, no doubt a reflection of increased corporate confidence, is essentially an admission of this lack of growth. This is nothing more than purchase of growth in an easy-money backdrop.

We have started each of the last few years with second-half recovery hopes, but the recovery doesn't seem to show up in the end. Maybe 'this time will be different', but shouldn't investors be a little more skeptical than they are at present?

Macro Risks Have Come Down

Some enthusiasts for the market rally also cite reduction in policy uncertainty about Europe and the U.S. fiscal situation.

This argument makes sense in the case of Europe as the ECB's actions have clearly brought down the temperatures in the Spanish and Italian government bond markets, which has given those countries enough fiscal space to put their houses in order. One could reasonably argue that the recent political problems of Spain's government and the coming weekend's election in Italy run counter to that goal. But the fact remains that ECB actions have effectively removed the Euro-zone break-up scenario from the table. And that is no small thing. That said, the consensus expectation of steady improvement in the region's economic fortunes appears to be overly optimistic. And the reality is that a recessionary Euro-zone is a problem for the world economy.

But while policy risks may have come down in Europe, we can't say the same about the U.S. economy. The 'Fiscal Cliff' was a big deal, but you would be hard pressed to find any evidence of market anxiety throughout December. The same appears to be the case with the budget sequester. Whether you look at the CBOE's VIX Index or any other measure of market anxiety, you won't find it. The market simply doesn't seem to care what happens on the budget front. I am not suggesting that the market should be for or against the sequester, but it's hard to imagine that it wouldn't take a stand through its pricing action on a roughly $100 billion annual spending cut.

Putting It All Together

As I mentioned today in the Roundtable Review, a lot of the optimism is Fed inspired. The Fed's easy money policy is giving an artificial boost to the stock market. How easy is it for companies to raise funds? Check out a bond issuance by Amazon.com (AMZN) late last year. Amazon is a well-run company and is most likely a credit worthy borrower, but it didn't pay much yield relative to the comparable U.S. Treasury bonds. Forget about strong companies like Amazon and others, even companies with junk credit profiles are paying very low yields relative to historical levels.

I am not asking you to fight the Fed – that's one losing battle. Just be careful with your investments and don't get swept up in the euphoria. The small and mid-cap space looks exciting, but appreciate the inherent risks associated with those stocks. A diversified portfolio should have some small cap exposure, but you should have plenty of defensive looking large-caps that pay growing dividends. There is no shortage of those ever green names. And rely on the discipline of the Zacks Rank to make stock picks, in whatever size category you are looking.

Focus List Update

We did not make any changes to the Focus List this week.

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