by Bob Doll, Chief Equity Strategist, Fundamental Equities, BlackRock
Equity markets responded well to last week's news flow (which included the US midterm election results, the Federal Reserve's announced launch of a second round of quantitative easing and a strong October labor market report) and posted significant gains. For the week, the Dow Jones Industrial Average climbed 2.9% to 11,444, the S&P 500 Index advanced 3.6% to 1,226 and the Nasdaq Composite rose 2.9% to 2,579. With these gains, markets are up double-digit percentages on a total return basis for the year as a whole and have advanced roughly 20% since their lows of mid-summer and, as has been widely reported, the Dow is back above the level it reached before the Lehman Brothers collapse in the autumn of 2008.
Last week's election results sent the message that voters are highly upset with the nature of the economic recovery and anxious about the future. The past few election cycles have been characterized by meaningful political change and heightened volatility, with the 2010 midterms marking the third consecutive election that resulted in a change of control in either the legislative or executive branch—the first time in history this has happened. From an investment perspective, we believe the results should make for a more market-friendly environment, and we are hopeful that Congress and President Obama will be able to come to terms on some important issues, including energy policy, extending free trade agreements and possibly even reducing spending and deficit levels. Both President Obama and congressional Republicans face some steep challenges, and both will have to compromise in order to govern effectively.
An issue of particular importance to many investors is the future direction of tax policy. In our view, the strength of the GOP victory makes it quite likely that Congress will push through some extension of the Bush-era tax cuts, which are set to expire at the end of 2010. We believe the most likely scenario is that the full package of cuts is extended for a year or two before a longer-term compromise is worked out. Should this happen, it would mean that the reduced tax rates on capital gains and dividends would remain intact for now, which would be a positive for equity markets. We hope Congress is able to work out some sort of temporary agreement in a lame-duck session later this year; should the issue get pushed out until 2011, it would mean at least a temporary de-facto increase in tax rates, which would be a negative for both the economy and stocks.
The other big news last week was, of course, the Fed finally announcing its long-awaited program of additional quantitative easing (known informally as "QE2"). The central bank announced that it would be purchasing an additional $600 billion in Treasury securities between now and next June. The Fed also indicated that it would leave itself the option of extending this program if conditions warranted and promised to "employ its policies as needed." At this point, we expect the Fed to continue to be aggressive in terms of combating deflation and promoting economic growth, at least until it sees a downturn in the unemployment rate. The job market has shown some signs of improvement recently, so perhaps the Fed will, in fact, be finished with QE2 by June. In our view, the Fed's actions have been, and will continue to be, a positive for risk assets (including stocks) and will also put further downward pressure on the US dollar.
The Fed's announcement comes at a time when the economy is still struggling, but has been showing some improvements of late. The most notable data from last week was the October jobs report released on Friday, which showed that a stronger-than-expected 150,000 jobs were created in October, representing notable upward revisions from prior months. The unemployment rate, however, remained elevated at 9.6%.
