It has been another roller coaster year for stock indexes. In June, the Dow Jones Industrial Average opened 24% higher than on June 1, 2010, but closed the month with a lower high and lower low from May. The Dow began 2011 at around 11,600, rallied near 13,000 in April and May, and then dipped below 12,000 in June. Movement in the S&P 500 was similar, as the S&P was up 23% from June 2010 to June 2011. Surprisingly, these numbers are very close to the gains the indexes made this time last year. Further, the chart patterns are similar to a buildup for the first part of the year and a selloff in May and June (see "Sell in May").
Once again, analysts are split on where the indexes are headed for the rest of the year, with some saying the market will make decent gains on the year while others say we already have seen the top for 2011. With differing predictions come differing ideas on what will drive markets for the rest of the year.
Similar to last year, recent economic reports and comments from Federal Reserve Chairman Ben Bernanke point to a slowdown in the recovery. In nearly every measure of the economy, Bernanke cited "economic downgrades" in his June press conference following the Federal Open Market Committee (FOMC) meeting where the Fed once again postponed an exit strategy from its long-term accommodative stance. In the press conference, he cut the Fed’s GDP projections for 2011 from 3.1%-3.3% to 2.7%-2.9%. "Part of the slowdown is temporary; part of it may be longer lasting. We don’t have a precise read on why this slower pace of growth is persisting," Bernanke said.
That slower pace is evident especially in the labor market where May and June non-farm payroll showed virtually zero growth. The Fed’s projections show the unemployment rate dropping to 8.4%-8.7% by year-end, but it has moved in the opposite direction since bottoming at 8.9% in March. "It’s not clear that we can get substantial improvements in payrolls without some additional inflation risks, and in my view we can’t achieve a sustainable recovery without keeping inflation under control," Bernanke said in the press conference.
Paul Larson, equities strategist at Morningstar, says macroeconomic factors have been driving the exceptional volatility we’ve seen in the market. "When you look at things from a company-by-company basis, things have been fairly tame and earnings have been very good. It’s not company performance that has been driving volatility," he says. In the short-term, Larson expects volatility to remain elevated but doesn’t expect large directional moves. He expects the indexes to close the year a couple of percentage points higher.
Spencer Patton, chief investment officer at Steel Vine Investments, says it is going to be very difficult to get above 1,350 in the S&P unless some exceptional news comes out from companies during earnings season. "A lot is going to depend on commodity prices. For a while it looked like we were going to have a bit of a break in some commodities, but now a lot have leveled off. We’re going to have a mixed picture during corporate earnings season," he says. He pegs support in the S&P 500 at 1,250, but expects it to reach 1,325-1,350 by year-end.
A lot of the market direction going forward will depend on measures of the economic recovery. "The consensus seems to be that there’s still a lot of concern about the economy as a whole, and that’s one of the key reasons why we refuse to move on interest rates," says Darin Newsom, senior analyst at Telvent DTN. Although he expects further slowing in the recovery, Newsom says investors still need to treat the stock market with caution. He expects the Dow to test resistance near 12,540 and begin to slide lower with long-term support at 10,762. He sees the same direction in the S&P and Nasdaq 100 with long-term support at 1,140 and 2,352 respectively.
Jeffrey Friedman, senior market strategist at Lind-Waldock, is bearish the markets in the short-term, but expects the year to end with a rally. "We’re sideways to lower right now. Come September, we’ll see some economic news that starts to beat estimates and we’ll start to rally," he says. "In the short-term, I’m a seller; in the longer-term, I’m optimistic." He says continuing worries about Greece and other periphery Eurozone nations as well as a slowdown in China will continue to put pressure on the markets before they break out. In the short-term, he expects the S&P to be range-bound at 1,260-1,325 and break out to end the year with a Santa Claus rally. In the Dow, he sees a range of 11,800-12,500, and if GDP nears 3% for the year, then it should be above 12,700 by December. The Nasdaq 100 will have a short-term range of 2,200-2,340 and hit 2,450 by Thanksgiving.
The three Es
Analysts say economic news, earnings and employment will move stock indexes for the rest of the year.
While a lot of focus in the first part of the year was on the sovereign debt crisis gripping the Eurozone, with special emphasis on Greece, a slowing of economic growth in China largely went unnoticed. Chris Mayer, managing editor for Agora Financial, says this latest slowing could have a significant impact on commodities and the rest of the market. "A lot of people haven’t really noticed, but China’s Purchasing Mangers' Index (PMI), which measures manufacturing activity, fell for the third straight month in June. China has had a huge impact on the whole commodity story and most commodities were down in the second quarter" (see "As goes China…").
This is a recent trend change as China has been a major buyer of commodities. "Demand from China has been strong across the commodity spectrum. China has been buying up all kinds of raw goods to feed its economic expansion. Name the commodity and chances are that it has increased in price significantly and one of the major reasons probably is China," Larson says.
Mayer says this easily could translate into a slowdown in some stocks. "We would see a continued underperformance from stocks involved in extracting commodities. The most sensitive would be in areas like steel and copper; less affected would be stocks around oil. If China contracts, oil probably will fall too, but it’s less vulnerable than a lot of the metals and steel stocks," he says.
In addition to economic news coming from around the globe, debt problems here in the United States bear watching. "We’re not in the same situation as Greece, our debt-to-GDP is much more tame, but we do have a large federal deficit that is approaching 10% of GDP. That gap is going to have to be closed at some point in the future because it isn’t sustainable," Larson says.
Earnings always have been a large factor in market moves and analysts are expecting nothing less now. In the first quarter, we generally saw higher earnings than were expected. Looking to the rest of the year, most analysts are expecting higher earnings to continue, although they don’t all agree on the reason.
"There are two ends for profits in corporations," Friedman says. "In the last eight quarters, it has been because productivity went up, employment went down and inventories were less. [They became] lean, mean, fighting machines. Companies are making employees work harder and paying them less, which swells [the] profit margin. The other way of making profits is more sales and more production. That’s the real growth and we’re not there."
Mayer says production is beginning to turn around. "When we had the financial crisis, companies cut back quite a bit. They let go of a lot of people, shuttered a lot of capacity and basically retrenched. Now that business has improved a little bit, it is translating into much better profits because they are coming off such a low base," he says.
Additionally, the recent drop in commodity prices and stabilization in energy prices should help companies’ bottom lines.
Employment will continue to be key to the strength of the recovery and to demand. Friedman says job creation is critical for the recovery. "Earnings won’t be that great going forward unless employment gets better. If you’re looking for one thing in the next twelve months, watch for job creation. If we don’t get job creation this time around, we will have the big double-dip," he says. "If you get people working, you’ll get expansion. If you get expansion, then you’ll have real growth of profit margins and investment confidence."
Finally, the Fed terminated its second round of quantitative easing (QE2) at the end of June, although the market barely reacted. "For all the Fed’s faults they have had over the years, it was well telegraphed to the market that QE2 was ending in June," Patton says. As to the possibility of a QE3, he says the Fed has set the bar very high for either a QE3 or other new stimulus measures.
Mayer says that even though the Fed telegraphed the end of QE2, there still was uncertainty. "A lot of people anticipated that when QE2 ended, the markets would fall apart because that’s basically what happened when QE1 ended. The market fell [about] 16% in the month after QE1 before they started talking about implementing QE2 and that hasn’t happened so far," he says.
So far, the Fed hasn’t hinted at a third round of quantitative easing, although Bernanke has said the Fed will continue to reinvest securities as they mature. So while it won’t be adding more liquidity to the marketplace, the Fed is not ready to begin withdrawing what it already has put in.
Follow the leader
The Nasdaq 100 was the first of the three major indexes to make new highs since the 2007-2008 plunge, a feat neither the Dow nor S&P have accomplished. It has led the other indexes in recent years. There is no consensus that will continue.
Friedman and Newsom both expect the Nasdaq to continue leading the other indexes. Newsom expects the Dow could struggle the most from a blue chip point of view if we don’t begin to see better economic news. Without more positive reports, he says stocks in general will have a difficult time, although the Nasdaq should not be as heavily hit as the Dow and S&P.
Mayer says he expects the Nasdaq will lag the Dow, but beat the S&P. "Just looking at the make-up of the indexes, some of the components of the Dow are pretty cheap on absolute terms and they ought to hold their ground pretty well," he says.
While the Nasdaq has done very well recently, Larson says he is expecting the market to experience quite a shake-up in the future. "A lot of the companies that have been left behind in this two-plus-year-old rally will be the ones to outperform in the future. Today’s laggards will be tomorrow’s leaders, and vice versa," he says.Where are we now?
There is no denying that equity indexes have experienced one of their greatest runs in history since the March 2009 lows. What isn’t so clear is where the market is going from here. Some technicians are still debating whether this is a secular bull market or simply a large correction from those lows (see "New bull or old bear?"). "When we start looking at the longer-term charts, some of these indicators, such as lower-lows and lower-highs, are signs that the longer-term trend may be turning down," Newsome says.
There still is a lot of uncertainty in the market, especially as it pertains to the recovery. With wild cards such as debt crises here and abroad, social unrest in parts of the world and government interventions, it is no surprise there are so many opinions. As a result, uncertainty and volatility have increased and that doesn’t appear to be changing anytime soon.