Improving Fundamentals Face Key Technical Hurdle

Significant Market Variables:
Earnings
Monetary Policy
Europe Debt Restructuring
Key S&P 500 Resistance at 1353/1370?

Equity markets posted strong gains in the first month of 2012, with the S&P 500 rising 4.5% in January. But just how sustainable is the recent rally in worldwide stock markets? Three factors will determine the future course of equities: 1) the pace of U.S. economic recovery and corporate earnings; 2) the ongoing Euro Zone crisis and attempts to prevent further deterioration of European sovereign debts; and 3) monetary policy in the U.S. and Europe. The U.S. earnings season has generally been positive thus far, with strong earnings from the technology and industrial sectors overshadowing weaker earnings from financials. S&P 500 earnings increased from $83.21 in 2010 to approximately $94.21 in 2011, and are projected to rise to $104.05 in 2012. That translates to a forward P/E ratio below 13 and an earnings yield around 7.7%, both quite attractive compared to a 10-year treasury yield below 2%.

January was a strong month for U.S. job growth. 243,000 jobs were added, bringing unemployment down to 8.3 percent, its lowest level in three years. Private-sector job growth has been positive for 23 months. Job growth is near the 'sweet spot:' not so strong that the Federal Reserve feels pressure to raise interest rates, but not so weak that it threatens consumption spending and the broader recovery. Another bright spot in recent economic reports was the January ISM non-manufacturing index reading of 56.8 percent, 3.8 percentage points higher than the December level and a sign of continued growth at a faster rate in the non-manufacturing sector.

The Federal Reserve has indicated they will keep policy rates low well into 2014, which has encouraged investors' appetites for equities. In fact, the more confident risk appetite in January led to the strongest increases in areas of the market which had been the poorest performers in the second half of 2011, including foreign and emerging markets, industrials, materials, financials, and small caps. Conversely, some of the best performing sectors in the second half of 2011 were the weakest sectors in January, including utilities and consumer staples. The risk aversion that emerged from the European sovereign debt crisis appears to have subsided for the moment, but the question remains: how much of the improving economic fundamentals and accommodative monetary policy is already priced into the stock market? And how will the market behave as it gets closer to and tests major resistance at last year's highs? We will soon find out, as the S&P 500 is currently within 2% of last year's peak. The attached chart shows the recent positive tenor of the markets, as reflected in the S&P 500. Several technical hurdles were cleared in late December and early January. The S&P broke out of the wedge pattern which had dominated trading during the fourth quarter. The market also rallied above its 200-day moving average (the red line) and its moving averages formed a bullish cross where the 50-day average (green line) surpassed the 200-day average. The current low-volatility uptrend has led to total return of nearly 12% since December 19, with only a temporary pullback of 1.2% along the way.

Are the equity markets entering a new phase of bullishness, or are investors simply ignoring the risks still very much with us? The VIX volatility index closed last week below 18, its lowest level since July of last year, a level that could indicate a high level of investor complacency. The European situation is not fully resolved--Greece needs another round of financing to avoid default--and our own government's fiscal imbalances will not be tackled in an election year. On the other hand, the gradually improving U.S. economic activity, accommodative Fed policies, and an apparently stabilizing European situation are all positives supporting asset prices. In the context of improving economic fundamentals and up- trending equity markets, we are optimistic that equity markets have discounted much of the bad news, and are in the process of discounting some of the more recent good news. However, any new shocks from Europe could lead to a substantial correction, especially as the S&P 500 climbs closer to its 2011 high and significant resistance level of 1370. We will be closely monitoring trading behavior for any indications of weakness around key resistance levels at 1353 and 1370. If a rally through those levels shows strong breadth and volume, we will feel comfortable adding exposure to higher beta sectors still recovering from last year's underperformance; but if we see signs that the current rally is losing steam, we will be ready to raise cash and/or hedge exposure to economically sensitive areas.