Buy American
The market’s gain during January has already exceeded its paltry return for the entirety of 2011. But that trend should continue, as a strengthening US economy further boosts the equity market.
By Benjamin Shepherd
This year has been a welcome respite from last year’s downside volatility. In fact, most of the major domestic stock indexes have posted greater gains in January alone than in all of 2011. The S&P 500 is up by more than 6 percent so far this year, the Dow Jones Industrial Average has gained more than 5 percent and the Russell 2000, the benchmark for small-cap performance, has gained 12.3 percent.
The investor optimism reflected by those gains is largely being driven by improving economic data.
With unemployment having fallen from 9.1 percent in January 2011 to 8.3 percent last month, an improving labor market has made a huge contribution to consumer confidence. In each of the past three months, the economy has added about 240,000 new jobs, and federal data shows that hiring activity across sectors exceeded layoffs. Even cyclically sensitive industries such as retailers and construction firms are adding workers to their payrolls.
Inventory growth has been another positive indicator in recent months. Businesses appear to be making a conscious decision to increase inventories of both durable and nondurable consumer goods in anticipation of improving sales.
Additionally, the fourth-quarter earnings season has been encouraging, with about 60 percent of earnings reports surprising to the upside. Overall, earnings grew by 5.8 percent in the fourth quarter, with information technology and industrials showing particularly strong growth at 12.3 percent and 12.1 percent, respectively. At the same time, stocks have remained relatively cheap, as the S&P 500 currently sports a 12-month forward PE ratio of 12.4, well below the average of 14.6 over the past decade.
While most of the news emanating from Europe is positive at the moment, the European sovereign-debt crisis still poses the greatest risk to equity markets.
However, the spreads on Spanish, Irish and Italian sovereign debt have narrowed in recent months as investors have become increasingly confident about the EU’s response to the crisis. The European Central Bank (ECB) has agreed to make important concessions in the restructuring of Greek debt, and Greece has made progress in its negotiations with private creditors. The ECB has offered unlimited three-year loans to European banks in a move to stem liquidity and credit crunches. And eurozone governments have agreed to pursue a new treaty aimed at reining in profligate spending by regional governments.
But the European crisis is by no means resolved and major structural reforms are still needed.
In Spain, for example, youth unemployment remains at around 50 percent. And Spanish banks are struggling with souring loans on overvalued properties, leading the government to estimate that the nation’s banks will need to set aside an additional EUR50 billion as a cushion against loan losses. That sum amounts to about 4 percent of the country’s gross domestic product (GDP) and it may not even be sufficient. Spanish banks have about EUR338 billion in property-related loans and assets on their books, of which EUR176 billion is currently classified as bad loans. If default rates spike, it will take considerably more than EUR50 billion to absorb the losses.
Considering that Spain is a microcosm of the problems facing Europe, there’s still quite a bit that could go wrong. Nevertheless, US investors are generally in a positive mood and that’s created solid gains from our US exposure.
Since we added SPDR Dow Jones Industrial Average (NYSE: DIA) to our Growth Portfolio last month, the fund has returned slightly more than 3.5 percent. Part of this gain is derived from the exchange-traded fund’s (ETF) 22.2 percent allocation to the industrials sector. Indeed, industrials such as Caterpillar (NYSE: CAT) and United Technologies (NYSE: UTX) have reported better than expected earnings. Even the financial sector is contributing to gains, with components JPMorgan Chase (NYSE: JPM) and American Express (NYSE: AXP) jumping 7.5 percent and 13 percent, respectively.
The only laggards thus far are Pfizer (NYSE: PFE), Coca-Cola (NYSE: KO), Johnson & Johnson (NYSE: JNJ) and Verizon Communications (NYSE: VZ).
Our S&P 500 Index tracking fund Rydex S&P 500 Equal Weight (NYS: RSP) has also produced a 9 percent gain year to date. The fund has managed to beat its benchmark index by applying an equal-weighted methodology to its portfolio, rather than the standard capitalization-weighted approach. As a result, mid-cap names account for 48.6 percent of assets. That weighting is a key factor in the fund’s outperformance relative to its benchmark.
While January was an extraordinarily positive month for our US positions, we expect continued improvement from the US economy and that should boost stocks further. In particular, the real estate market should finally bottom out during the first half of the year. Of course, there could still be a mild recession in Europe. But that should be offset by China’s economy, which is still growing in excess of 8 percent annualized. Although that’s a marked slowdown from the torrid pace of China’s growth in recent years, it should still provide ample support for Chinese consumption, which should benefit US companies.
So while we look for further gains from our Chinese and emerging market exposure, we expect our US exposure to contribute significantly to our Model Portfolio’s total return this year.
To capitalize on an improving US economy, continue buying SPDR Dow Jones Industrial Average below 130 and Rydex S&P 500 Equal Weight under 55.