One and a Half Cents on the Fourth Quarter

written on November 08, 2010 by Frank Fantozzi

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As the calendar turned to fall, the markets began to rise.  While bonds posted a respectable 2.5% gain for the third quarter, measured by the Barclays Aggregate Bond index, the S&P 500 posted an outstanding 11% gain for the third quarter.  This performance was driven by an unusually strong September.  The gains during the quarter were far from steady.  Volatility was high as the S&P 500 moved up and down—and up again—within a 10% trading range during much of the quarter.  Despite the strong gains in September, the stock market ended the third quarter not far from where it began the year.

Investors may also look forward to the market posting gains by year-end as key drivers combine to lift stocks out of their third quarter trading range.  Here is my “one-and-a-half cents” worth of insight on the potential positives investors are likely to see during October:
• A one and a half (not double) dip for the economy.  Slow, but positive economic growth is likely to support modest stock market gains in the fourth quarter.
One and a half chambers of Congress go to the Republican Party (GOP) in the mid-term election.  The GOP is likely to take the majority in the House and will hold about half of the Senate.  The return of political balance in Washington between the parties may slow the pace of legislative change and result in the “gridlock” the market has historically favored.  In addition, depending on the outcome of the election, it is possible PAYGO (Pay-As-You-Go) rules that require budget offsets to any tax cuts are waived allowing the extension of many, if not all, of the Bush tax cuts into 2011.
• “QE Version 1.5” from the Fed.  At the Federal Reserve meeting on November 3, 2010 the Fed is likely to announce additional stimulus measures to improve economic growth.  The coming bond purchases may be half the size of quantitative (QE) version 1 (the first round of QE the Fed enacted during 2008 and 2009).

Finally, the fourth quarter of mid-term election years is almost always favorable for stocks.  The market’s reaction to mid-term elections, as uncertainty fades, has almost always been positive, with fourth quarter gains as measured by the S&P 500 index averaging 8% in mid-term election years.  The only two exceptions to the gains in the fourth quarter of every mid-term election year since 1950 were 1978 and 1994, when the Fed was hiking rates aggressively, a critical factor that is highly unlikely to take place this quarter.  So far, stock market performance in 2010 has tracked the typical pattern for U.S. stocks in mid-term election years, albeit with a bit more than the usual volatility.  The volatility that has been the key characteristic of this year’s stock market performance is likely to continue but should present opportunities for those investors patient enough to ride the market’s ups and downs.

Current Market Details
China rate hike and mortgage worries fueled biggest one-day selloff in two months.
  China's surprise rate hike, though just 25 basis points, caught markets by surprise and sparked a global sell-off in risk assets and rally in the dollar.  One day does not make a trend, but in effect we saw a reversal of the reflation trade, i.e., a weak dollar and higher commodities, that has been in place since Bernanke signaled more stimulus was coming about six weeks ago.  The ongoing mortgage documentation debacle also weighed on stocks, while the earnings news was not good enough to outweigh the macro headlines.  Energy and Materials led the slide with losses over two percent.  All ten S&P 500 sectors fell, though Utilities lost just 0.6%.  Final tallies: Dow -165.07 to 10978.62, NASDAQ -43.71 to 2436.95, S&P 500 -18.81 (-1.6%) to 1165.90.

Tuesday's losses A weak dollar and mostly well-received earnings are helping stocks at the open.  The economic calendar includes the Fed's beige book, which is expected to reflect a subdued pace of growth and suggest further monetary stimulus is forthcoming.  Overseas markets were mixed, with European stocks higher after the Bank of England signaled more quantitative easing, while Asian stocks pared early losses after China's first rate hike in nearly three years.  Agricultural commodities and energy prices are broadly higher, while most key metals are flat.
 China's 7 AM announcement yesterday that it would be increasing deposit rates led to a sharp one-day reversal of the Operation Reflation trade.  Traders who were caught on the wrong side of the market bought back the dollar and drove the biggest one-day dollar rally since August 11.  In response, gold fell 2.7% - the biggest decline since late July - and other commodities (copper -2.5%) suffered as well along with stocks - particularly the commodity sensitive sectors of Materials and Energy.  We do not think this reversal will last and the reflation theme will quickly re-emerge.  However, it is an important reminder of the volatility that accompanies this investment theme which could repeat on or around the November 3 Fed meeting.
 Financials earnings show signs of improvement but mortgage mess dominates.  Resilient net interest margins from Wells Fargo and others suggest that expectations for the impact of the flattening yield curve on bank profitability may have been overdone.  Modest loan growth from US Bancorp provides a glimmer of sunlight through the lending clouds.  And credit improvement continues to benefit bank earnings.  The market is solely focused on the mortgage mess, however, so these incremental positives are being ignored.  We maintain our neutral view on Financials and continue to try to gauge the impact of the mortgage documentation issues on the banks.
 Mortgage applications fell sharply in the latest week.  Mortgage applications fell 10.5% in the week ending October 15 (versus the prior week), but are up 40% from a year ago.  Applications for both home purchase (-6.7% week-over-week) and refinance (-11.2% week-over-week) fell sharply.  The big drop in applications came as mortgage rates increased from the prior week.  The mortgage market is likely to be a key component (and barometer) of the Fed's next foray into quantitative easing.  By keeping rates lower for longer, the Fed is trying to encourage every homeowner and business property owner to refinance at lower rates, and then take the savings from the new, lower monthly payment and spend or invest it.  The market will be watching the mortgage market very closely as it assesses the effectiveness of quantitative easing.
 The Fed's Beige Book is due out.  Two weeks prior to each of the eight Federal Open Market Committee (FOMC) meetings each year, the Fed publishes the "Beige Book", a qualitative assessment of the state of the economy in each of the 12 regional Federal Reserve districts (Boston, New York, Philadelphia, Richmond, Atlanta, etc).  The comments come from small business and banking contacts in each district, and describe bank lending, housing activity, hiring, tourism, commercial real estate, agriculture, and virtually every other aspect of the economy from the bottom up.  The tone of the Beige Book is often reflected in comments made by Fed officials, and the tone of the Beige Book typically carries over into the FOMC discussion and makes it into the FOMC statement.
 Treasuries had sold off sharply Wednesday, with yields higher by 5-6 basis points (bps), but then bounced back following the selloff in equities over the China rate hike announcement.  Yields finished the day 2 bps lower, as the benchmark 10-year note closed at 2.48%. Spread sectors held up relatively well as the spread on high-yield bonds and emerging markets debt widened by 2 and 4 bps, respectively.
 The Treasury International Capital (TIC) data as of the end of August showed overseas investors were net buyers of $117 billion of notes and bonds for the month.  At $868 billion, China maintained its position as the top holder of Treasury securities, followed by Japan.  The currency intervention move last month by the Bank of Japan (BOJ) to weaken the yen fueled speculation that Japan would overtake China's position.  However, the TIC data is released with a six-week lag and does not reflect purchases of Treasuries by the BOJ with its currency reserves since its announcement.
 Over the past week, the LPL Financial Current Conditions Index was relatively unchanged at 218.  The level of the CCI indicates an environment fostering growth in the economy and markets.  The CCI is off of the highs of the year back in April, but has stabilized over recent months even as monthly and quarterly economic reports have been volatile.  Most components of the CCI point to an environment of slow growth, with the year-over-year change in Shipping Traffic the notable exception with off-the-chart growth that has slowed in recent months.  The 13-week change in Shipping Traffic reflects a blip 13 weeks ago rather than in the latest week.  Shipping Traffic has shown a steady, but slower pace since April of this year.  Retail sales were weaker posting one of the smallest year-over-year sales gains of 2010.  Mortgage Applications also showed some weakness with mortgage rates rebounding slightly from the lows.
 Biases in Our Recommended Models.  Broad Asset Allocation: we expect near-term pressure in the equity markets due to the double-digit rally in the S&P 500 since September, a less-than-stellar third quarter earnings season (especially on the revenue front), and lingering soft spots in the economy.  As such, we are underweight equities and overweight fixed-income and cash relative to our strategic weights.  Asset Class Biases: given our reflation theme, we prefer investments that may benefit from a weaker US dollar and higher inflation (commodities, REITs, emerging markets equity and bonds, and unhedged global bonds).  We also prefer yield to cushion market volatility (REITs, high yield bonds and emerging markets debt).  Equity Sectors: we have a bias toward economically sensitive cyclicals that may benefit from rising commodity prices (industrials, materials, and energy).  Please see the most recent Portfolio Compass and Compass Points for a complete summary of our investment thoughts.


Q: Will quantitative easing (QE) increase inflation, hurt the consumer, or both?
We don't expect quantitative easing to reignite 70s-style inflation (10-15%), but the likely weakness in the dollar as the result of QE may push up on the prices of imported goods like oil.  At the same time, the aim of QE is to reinvigorate the economy, which in turn, should boost hiring and wages.

Q: Is the foreclosure moratorium a breakdown in the capital system (i.e. parties breaking a contract)?
It is mostly a case of lost paperwork and an outdated process that is too cumbersome to handle the millions of foreclosures taking place.  The foreclosure process involves the review of documents and in many cases, with the mergers and sales of mortgage firms in recent years; the paperwork is incomplete, lost, or disorganized.  Millions of mortgages in the foreclosure pipeline or already through the process may face legal challenges because of questions about the validity of documents.  Bank of America, JPMorgan Chase & Co., and Ally Financial Inc.'s GMAC Mortgage unit froze seizures or evictions in 23 states to check whether faulty documents were used to confiscate homes.  The potential cost to verify documents in order to foreclose likely will lead to a rise in alternatives to foreclosure that serve the same purpose such as short sales, when lenders agree to let homeowners sell properties for less than they owe on the mortgage.  The impact on the economy is fairly limited, but the additional cost to the banks in the form of delays and litigation expenses is material and weighing on the Financials sector which continues to be the worst performer.

Q: Is there a piece forthcoming that discusses the longer-term investment outlook?
We are currently working on our Outlook 2011 series of publications (white paper, presentation, client letter, and seminar invitation) due to be published in early December.  These documents detail our perspective on the economy and markets and how to invest in the year to come.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  All performance referenced is historical and is no guarantee of future results.  All indices are unmanaged and cannot be invested into directly.  The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.  Securities offered through LPL Financial. Member FINRA/SIPC.

Frank Fantozzi

Planned Financial Services