The stock market started a second consecutive year with decent gains. Measured by the indexes, the S&P 500 ended January up 35.6 points, or about 2.72%; the Dow Jones Industrial Average was up 217 points, or about 1.72%; and the Nasdaq 100 was up 144.25 points, or about 5.85% (see “January rising,” below). “It’s been a very good January and if you believe history, then that portends some good things for the market,” says Paul Larson, equities strategist at Morningstar. “Taking a step back, the median stock is about 7% undervalued.” Although these are solid gains to start the year, analysts remain split as to the underlying reason for them. 
Brad Sorensen, director of market and sector analysis at Charles Schwab, is one who says things are beginning to improve. “We’ve seen a little more of a return to more ‘traditional’ market analysis that focuses more on earnings,” he says. “The employment picture in the United States and Europe [sovereign debt] still are in the picture, but they’re not the overriding factors that they were last year.”
On the other hand, Keith Springer, president of Springer Financial Advisors, says little has changed from last year and stocks are climbing a wall of worry. “We’ve got Europe ready to explode again, but it’s the evil we know; we have the U.S. slowing; we had the Fed come out and say it’s keeping interest rates low [until late-2014], that indicates that the economy is slowing,” he says. “But, you have a disbelieving public. If you add all those together, then the market climbs that wall of worry. If it’s obvious, it’s obviously wrong.”
Both point to the same underlying data and come to drastically different conclusions. Here we will look at how earnings, U.S. employment, the Fed and the European sovereign debt crisis are affecting the stock market.
Stock earnings
Overall, earnings proved a high point in the first quarter with a number of companies beating analysts’ estimates, particularly in sales. Notable were Apple (AAPL), Netflix (NFLX) and Green Mountain (GMCR).
Although improved sales bode well for a beleaguered economy, JJ Kinahan, chief derivatives strategist at TD Ameritrade, says other factors are beginning to drag on earnings. “We’re seeing steady growth in these companies, but one of the problems we’re seeing in some is margin. They either will have to get out of ventures with very low margin or raise prices,” he says.
Springer says earnings have been the driving force in rising stock prices despite a less-than-stellar U.S. economy. “What we’ve had are decent corporate earnings,” he says. “You can have the worst economic numbers in the world, but if corporations are being efficient, then they can make profits.”
Chris Mayer, managing editor for Agora Financial, says many companies used the 2008 crisis to become more efficient and are reticent about expanding at this time. “We had a similar story in 2011 where earnings were all right while the macro economy seemed so lame. One reason is that the 2008 crisis was very severe and companies got very lean,” Mayer says. “Because they’ve been slow to expand coming out of that, they have the ability to produce some good earnings even if volumes don’t pick up to where they were before.”
Looking ahead to the rest of 2012, Mayer expects small-cap miners and U.S. real estate to outperform the rest of the market. He says miners are “a natural place to look for a rebound because the underlying commodities haven’t fallen as far as the stocks.” One miner he likes is Kronos Worldwide (KRO). In real estate, he says prices have fallen to attractive levels and there are some interesting ways of playing that market. He likes Howard Hughes Corp. (HHC). Conversely, Mayer expects utilities to underperform, saying they had a good year last year, but valuations are starting to get a little high (see “At a glance”).
While earnings have been solid in recent years, many investors are waiting on the economy pick-up and though we are seeing some improvement in the jobs outlook, many analysts view those numbers with skepticism. Although January nonfarm payroll showed an increase of 243,000 jobs, the second consecutive month of better-than-expected job growth, and the unemployment rate dropped to 8.3%, that rate is somewhat skewed by the long-time unemployed (discouraged workers) falling out of the survey (see “Better, but still bad”).
Equities rallied following the better-than-expected January jobs number and Treasuries fell. Sorensen says the improving employment situation is helping stocks. “It’s certainly not a rapid improvement, but we are seeing better numbers — jobless claims are coming down substantially, and we’ve seen the unemployment rate come down. Everyone would like to see a more rapid pace, but things are improving,” he says.
In 2012, Sorensen is expecting information technology and industrials to outperform the rest of the market. He is starting to see investor flows out of defense, which outperformed in 2011, into more cyclical names as the economic data is improving. Conversely, Sorensen agrees that utilities will underperform and adds consumer staples to the list, saying valuations in both sectors are getting a little concerning after last year’s run in those sectors.
A Fed on hold
Considering that unemployment remains high, housing prices continue to bottom bounce and inflation lingers around negligible, it wasn’t surprising that the Federal Open Market Committee (FOMC) decided to keep rates steady at its January meeting.
Since last August, the Fed has maintained that it likely would keep rates low until mid-2013. Now, that time frame has been extended to late-2014. “The Fed still is on pins and needles like the rest of the market because, while the economy clearly is recovering, it’s not a robust recovery,” Larson says. “Historically, the deeper the recession, the stronger the rebound coming out of the recession. This particular recession was very severe, but the rebound has been below average.”
Springer says the Fed is hoping to see a trickle-down wealth effect occur by keeping rates historically low for so long. “All that liquidity has to go somewhere, and it speculates on stocks, which is what the Fed wants. It’s hoping people go out there and borrow to hire people, but it knows the wealth effect has a lot to do with it,” he says. “If the stock market goes up and people’s 401Ks go up, then people feel [wealthier] and they spend.”
On the other hand, Sorensen says the Fed is seeing diminishing returns on its investments into the economy. “The Fed’s impact on stocks isn’t as big as it’s been in the past. In some ways, it has policied itself into irrelevancy,” he says.
In addition to extending its commitment to keep rates low, the Fed also announced an official inflation target of 2%, something Fed Chairman Ben Bernanke had championed. “Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates,” the Fed said in a statement.
Between these two events, more discussion is mounting over the possibility of a third round of quantitative easing (QE3). Larson says that if the dollar continues to strengthen relative to other currencies, then pressure is going to build, and he puts the odds at 50/50 by this summer.The effect QE3 would have on the stock market also has become hotly contested. Sorensen maintains that any form of QE3 would be a serious blow to the stock market. “It would tell the market that things are worse than what the market believes and that the Fed doesn’t have any new ideas to help things out,” he says. “There would be a lot of skepticism about why we’re doing this when QE2 didn’t really have much of an impact.”
Springer disagrees and says QE3 would be a positive for the markets. “Everybody knows how bad it is,” Springer says, adding, “QE3 would give you all the tools you need to overcome it as an investor.” In 2012, Springer expects technology and emerging markets to outperform the rest of the market. He says technology helps companies replace workers and do things more efficiently. “If you can lay off five people and buy a software package to do the work of those five people, you’re going to do it,” he says. In technology, he likes Apple (AAPL) or anything to do with high-speed Internet, such as Broadcom (BRCM).
He says emerging markets will continue to be strong as long as our interest rates stay low. To access these markets, he likes the exchange-traded fund Emerging Markets Consumer Titans Fund (ECON).
Additionally, Springer believes housing and financials will have a hard time this year because those two sectors currently are doing better than they should be. He said people have bid these up despite the poor economy, but things will get worse because banks have so much of their money in housing and trading is going to slow at investment banks as regulations are implemented.
Following Europe
As much as we’ve discussed fundamentals based in the United States, the European sovereign debt crisis continues to dominate trade decisions. “The market still dances to whatever comes out of the EU crisis,” Mayer says. “Anytime we have bad news or it looks like the negotiations aren’t going well, then the market reacts negatively. Anytime there is any kind of advance, no matter how insignificant, the market seems to rally.”
Although very little has changed since the issue first came to light in May 2010, the situation appears less dire. “What we’ve seen with Europe is that the Armageddon scenario largely has been taken off the table with the European Central Bank announcing its three-year loan program last year,” Sorensen says. “We’ve seen yields come down on European sovereign debt in a lot of countries and we’ve seen the market not hanging on every word to come out of Europe.”
Even with these improving signs from Europe, Larson says it continues to be the biggest bearish factor affecting stocks. “The problems we have there with massive budget deficits and [unsustainable] debt-to-GDP ratios still are with us,” he says.
Larson expects basic materials and energy to perform well in 2012. These two sectors are economically sensitive and have been left for dead as investors traded risk-off and sought safer investments, he says. In basic materials, he likes Vulcan Materials (VMC) and in energies he likes Energy Transfer Equity (ETE). On the other hand, he feels consumer staples look pricey.
Thus far the EU has done little more than defer the problem, a strategy Kinahan says has largely worked so far. “The European strategy that seems to be paying off is kicking the can down the road and hoping that time will heal that wound. It’s interesting that the one country that took its medicine, Ireland, is the one that has suffered the most,” he says.
Kinahan expects the global economy to begin to pick up in 2012 and says there will be pent-up demand for higher quality goods. As such, he is expecting mid-level retailers as well as food companies and restaurants to do well. Additionally, he believes financials will do well because they have withstood so much already and management at these companies has become stronger.
Although there are signs of improvement in both the U.S. economy and the European sovereign debt crisis, plenty of negative sentiment remains. Stock performance was good in January and that historically has been good for the market, but January 2011 was good as well, and the year ended basically as a wash for the indexes. The Fed already has indicated it doesn’t expect significant improvement until late-2014. If we keep getting positive numbers like January’s nonfarm payroll, it may have to move up its projections.
