CWS Market Review – January 6, 2012

The stock market has gotten off to a good start in 2012. The S&P 500 has risen all three trading days this year and is already in the black by 1.87%. Of course it’s still early, but after all the frustrations of 2011 I’m happy to see some gains.

The S&P 500 closed Thursday at 1,281.06 which is its highest close since October 28th, and it’s a wee 0.33% rally away from hitting a five-month high. Since October 3rd, the index has surged more than 16.5%. There could be more good news ahead—the S&P 500 is currently above both its 50- and 200-day moving averages and that’s often a sign of a strong market.

Some of our Buy List stocks are also enjoying a nice rally. Through Thursday, JPMorgan Chase ($JPM) is up 7.31% for the year. Hudson City ($HCBK), one of our new picks, is up 6.72% and Ford ($F), a big under-performer last year, is up by 7.71%. It’s interesting that many of our poorer-performing stocks from 2011 are leading the charge so far in 2012.

In this issue of CWS Market Review, I want to explain an important market development in more depth. Namely, the U.S. market continues to divorce itself from the mess in Europe. I’ve talked about this in recent issues of CWS Market Review, but we’re really seeing this trend accelerate.

Putting it in basic terms, a weaker euro no longer automatically means a weak U.S. stock market. From mid-September until mid-December, the weak euro/weak market connection had been the rule. But as the Santa Claus Rally arrived and boosted U.S. stocks, the euro continued to sink like a…well, European Union currency. The euro just hit a 15-month low against the U.S. dollar.

What really caught my eye was on Thursday when Italian bond yields jumped back above 7% despite buying by the ECB. Seven percent is considered to be the point at which people who worry about such things start to worry. Not too long ago, 7% rates in Italy would have almost surely triggered selling in our market. But not this time. U.S. stocks took the news in stride.

So why is the U.S. market disentangling itself from Europe? The reason is that the economic news continues to look promising. For example, Tuesday’s ISM report came in at 53.9 which was above expectations. That’s the 29th report in a row signaling an economic expansion. Earlier this year the ISM plunged, and that was one of the signs Double Dippers took for an imminent recession. They were wrong. The ISM quickly stabilized itself and the December report was the highest in six months.

I like to keep a close eye on the monthly ISM report because it has a good tracking record of lining up with recessions and expansions. For now, a reading of 53.9 is well inside the safe zone. The ISM has fallen between 53.0 and 55.0 a total of 100 times and just two of those have been official recessions.

As hard as it may be to believe, even U.S. manufacturing is coming back to life. But the most encouraging economic news came on Thursday when the private payroll company ADP ($ADP) said that the U.S. economy created 325,000 new jobs last month. That was a huge shocker. Wall Street was expecting 178,000.

I have to explain that the ADP report is just the pre-game show. The big kahuna is the official Labor Department report which comes out Friday morning (be sure to check the blog for the latest). The ADP report is welcome news because the jobs market has been one area of the economy that has shown almost zero improvement. Let me caution you that the ADP report isn’t always an accurate bellwether of the government’s report. But if it is, then this would be one of the best jobs reports in years. The consensus on Wall Street is for an increase of 150,000 in nonfarm payrolls.

I want to be clear that the economy is still in very bad shape and millions of Americans are without jobs, but after three years we may finally have evidence of good news. Green shoots, at last.

So what does this mean for us investors? One outcome would be higher bond yields. Actually, that’s already happening as Treasury yields have gradually climbed higher since December 19th. On Thursday, the 30-year T-bond got to 3.06% which is the highest yield in nearly a month. The yield on the 10-year has soared all the way to—are you sitting down?—2.03%. Ok, ok, that’s still very low, but bear in mind that it’s an increase of 30 basis points since September 22nd. (By the way, I think September 2011 may have marked a generational low in bond yields).

Another effect of stronger economic data is that the underperformance of cyclical stocks has most likely passed. Last year, I warned investors to steer clear of stocks of companies whose businesses are heavily tied to the economic cycle (energy, transports, industrials, etc.). Early in 2011 cyclicals started to underperform, and by the summer, the bottom fell out. In less than three months, the Morgan Stanley Cyclical Index (^CYC) lost one-third of its value. Now, however, cyclicals aren’t nearly as dangerous. For us, this means that Buy List stocks like Ford ($F), Harris ($HRS) and Moog ($MOG-A) have a good shot of being our top performers this year.

Earlier I mentioned how some of last year’s duds now look like star performers. It’s not just happening on our Buy List. Look at the Homebuilder ETF ($XHB) which has soared 44% in the last three months. This is a sector that’s seen almost nothing but bad news for years. Even the financials, particularly the non-bank financials, are showing some life. Since December 19th, the Financials ETF ($XLF) has added 10%.

While the macro-economy is getting better, I need to explain one apparent contradiction and that’s that the news for corporate profits won’t be as good. Corporate profits had been the one area of the economy that was doing fairly well. For the last several quarters, companies consistently beat analysts’ expectations.

But now companies have been busy lowering expectations. Just this week, both Target ($TGT) and Eli Lilly ($LLY) gave lower earnings guidance. Part of this is about managing expectations. But another part is that many companies have run out of room to increase profit margins. Until now, they’ve increased margins not by raising prices but by cutting costs. In other words, laying people off. Oddly enough, the corporate earnings story is the opposite side of the coin of the jobs story.

Make no mistake, earnings are still good. They just won’t be quite as good as many people thought a few weeks ago. Wall Street currently expects the S&P 500 to earn $24.31 for Q4. That’s an increase of 10.85% over a year ago, but it’s a drop of 3.88% from Q3. (I should also mention that what’s left of AIG will have an unusual impact on overall earnings.) If that forecast is right, it would bring the full-year total for 2011 to $97.02. Again, let’s look at the big picture: that’s a 70% increase from two years before.

There are lots of good bargains on the Buy List. Wright Express ($WXS) looks good. CA Technologies ($CA), one of our new stocks, also looks good here. AFLAC ($AFL) got as high as $45.27 on Thursday which is its highest price in a month. Plus, shares of Ford ($F) look like they’re about to break out above $12. The upcoming earnings season should be a big help for us.

That’s all for now. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Posted by on January 6th, 2012 at 5:20 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.