Bob Doll: Market Rally Continues

The continuing trends of some “less bad” economic news and optimism over the prospects for additional quantitative easing by the Federal Reserve helped risk assets, and equities in particular, to post gains yet again last week. For the week, the Dow Jones Industrial Average climbed 0.5% to 11,062, the S&P 500 Index advanced 1.0% to 1,176 and the Nasdaq Composite rose 2.8% to 2,468.

On the economic front, data releases over the past month have been relatively encouraging, and have been consistent with our view that the economy is growing at a modest (but still positive) pace. In the corporate landscape, durable goods orders have turned positive and the nonmanufacturing sector (the sector that produces the most jobs) has been showing signs of strength. Consumer spending also posted a modest uptick in August. The labor market has continued to struggle, but even that area of the economy has been showing modest signs of growth. Initial jobless claims were higher than expected last week, which interrupted a seven-week trend of improvements on that front. Private payrolls have been growing (with September marking the ninth consecutive month of gains), but those gains have not been enough to bring down the unemployment rate. This is a trend we expect will continue for some time, as the unemployment rate will likely remain elevated for the next several years.

One area of the economy that continues to struggle has been the housing market. The debate over foreclosures has been making headlines recently as attorneys general nationwide have launched investigations into the foreclosure process. Additionally, some banks have put foreclosure moratoriums in place to examine their foreclosure processes. Regardless of how it all plays out, this situation is likely to prolong the housing market weakness.

In addition to very modest economic growth over the past many months, we have also seen very modest levels of inflation. While producer prices did rise more than expected in September, the core reading that excludes food and energy was relatively tame. Over the past 10 months, core prices have increased by 0.1% seven times, which shows that inflation remains barely above the zero line.

The Fed has indicated that it is growing increasingly uncomfortable with the threat of deflation, and as we have discussed in recent weeks, it seems all but assured that the central bank will soon be engaging in a new round of quantitative easing. At this point, it seems less a question of “whether” or “when” the Fed will act and more a question of “how.” We expect the Fed will remain flexible in its easing program, but also believe its asset purchases will be large enough to extend the Treasury market rally.

The prospect for additional Fed action has resulted in a continued weakening of the US dollar, an event associated with the rising risks of protectionism and trade wars. With most countries emerging from the recent financial crisis with less-than-robust exporting activity, many are in the process of attempting to devalue their currencies to boost trade. Obviously, from a mathematical perspective, not all currencies can depreciate against the rest, and some country must buy another’s goods if anyone’s exports are to increase. Given this backdrop, we have been seeing rising tensions around currency and trade issues, particularly between Washington and Beijing. The United States has been carping that China has been unfairly manipulating its currency, while China is complaining about super-loose monetary policies in the Western world. The risk is that the world slips into a currency war that leads to greater protectionist trade policies, which, in turn, act to slow global economic growth. This has not yet happened, but remains a risk worth monitoring.

Also on the geopolitical front are the upcoming US midterm elections. The elections could have a broad influence on trade, tax and regulatory policies, all of which could have some impact on the markets. At present, the odds are growing that the Republicans could take over at least one of the Congressional houses. The consensus view is calling for an 80% chance that the GOP will take over the House of Representatives, and while some are suggesting that they will also make enough gains to take control of the Senate, chances are that they will fall one or two seats short of that goal.

The macro backdrop of improving economic data and the likelihood for additional Fed action has helped stock markets to move noticeably higher over the past several weeks. Over the long term, we believe that modest levels of growth should be enough to allow corporate earnings to continue to make gains and push markets higher. (Initial indications are that third-quarter earnings results are shaping up to be better than expected.) Although we are generally positive about the prospects for stocks in the months and years ahead, we would sound a note of caution. Because stock markets have advanced so strongly over the past several weeks (at least in part over expectations of additional easing), we may be looking at a classic “buy the rumor, sell the news” scenario that could cause a near-term setback at some point later this year. In any case, we believe that the economic, earnings and valuation backdrop makes for an attractive longer-term case for equities.