MARKET OUTLOOK 2012
With 2011 nearly in the record books it is time to reflect on this past year and look ahead to what the New Year will bring. With two plus weeks left in 2011, it has ended up being a flat year that was split between a more positive market during the first half, followed by a major sell off in the summer and consolidation. The Standard and Poors 500 index (SPX) closed December 14, 2011 at 1211.82 vs. a December 31, 2010 close of 1257.64. The rally that originally began in March 2009 carried through until a May 2 top at 1370.58 which had the SPX up 9% for the year.
This 1370.58 proved to be the high of the year in the SPX as it then corrected to 1258 which was a near perfect test of its 200 day moving average and also the yearly open price. This is very common as opening prices are often tested and are important points of support and resistance in markets. The buyers reemerged and the market rallied into early July but was unable to make new highs. It was during July that the political battle began over the U.S. debt and a crisis of confidence in global financial leadership began.
It is our belief that this lack of confidence has been directly responsible for the volatility and market weakness during the second half of 2011.
The early August headlines focused on the potential for a government default on U.S. debt. While this scenario was probably never likely, the kicker came when the debt rating was downgraded. The SPX fell during this time to an August 9 low of 1101.54 before rallying back above 1200 in only a few trading sessions. As reality set in however, the focus shifted to sovereign debt issues throughout Europe and the markets made one more assault on the downside bottoming at 1074.77 on October 4. This proved to be the yearly low as a 20% rally during October began and peaked at 1292.66 on October 27. Again, the market has struggled with staying above its technical resistance of its 200 day moving average and has not been able to find any more upside.
The fixed income markets have remained pressured by interest rates that are historically low, but bound by zero on the downside and a Federal Reserve set to keep rates low. The 10 year U.S. Treasury bill has traded below 2.0% and is currently at 1.95%. While the U.S. economy has given some mixed signals, the outlook in Europe remains much more negative. It appears the U.S. will struggle to grow meaningfully, but recession seems unavoidable in the Euro Zone. News of potential new packages and plans to deal with the European issues has held the U.S. markets captive as well.
PRESIDENTIAL CYCLE
One of the patterns that has historically been reliable as a guide for equity performance is the four year presidential cycle. Typically, the year before the election (2011) is the best performing year of the four. Recent history has backed this up as 2007 was up 11% before topping and closed up 5.5%. The bear market ended and a new bull market began in 2003 as the SPX rose 28.8%. The three pre election years in the rocking 90s, 1991, 1995, and 1999 were all block buster years in the market with large percentage gains. Thus, it appears for the first time in two decades the year prior may be a loser. However, even if we get enough year-end rally to put the SPX in the black for the year it will not be a large percentage gainer. This is a fairly normal consolidation; however, considering the nice percentage move that has been made since the bull market began in March, 2009. Different politics and competing agendas always impact the markets and this election should be no different.
ECONOMY
Economic growth in the U.S. is estimated to be slightly over 2% in 2012 and recent reports have been more positive. While this is not a growth rate to excite markets, it is clearly better than other developed countries, particularly in Europe. We believe the U.S. is hovering near neutral but actually may avoid a new recession. Europe is likely headed into a recession as the only entity that can have a major impact, the European Central Bank, has been reluctant to write a blank check to bail out failing countries. The issue is probably not if some countries in the Euro zone fail, but if they collapse or if an orderly liquidation can be achieved. There is a huge demand for capital funding in the Euro zone next year that may or may not be met.
There could be a collapse in the Euro Currency, gold has pulled back dramatically and the interest rates in the U.S. remain low and the Federal Reserve has indicated they will remain low for the next several quarters. Yet there is very little growth as the huge amount of debt that built up over the past few decades is continuing to unwind. This had an impact on the credit crunch/mortgage debacle in the United States, and is working its way through all areas of the economies worldwide. This includes consumers, companies and governments. While companies have high amounts of cash, they are electing to raise dividends and buy back stock more than hire new employees as managements appear concerned over more problems in the future and a crisis of confidence in leadership in Washington grows.
Given the uncertainty we expect investors to continue to buy U.S. Treasuries despite their incredibly low yields. The primary investing theme since July has been to sell assets and reduce risk. This has led to a sell off then consolidation in equity markets, a 5% rise in the U.S. dollar and general upward pressure on commodities until the recent round of selling. The deleveraging should continue and this will make it challenging to create growth and for investors to find good risk adjusted returns. Unfortunately, we expect this process to last for many years and as traders and investors we must adapt to the new climate. This includes our analysis tools, many of which may not work as well in this type of rate environment. The 10 year U.S. Treasury rate was 3.3% at the start of 2011 and is currently at 1.85%. We expect it to hover near the 2.0% range as a new “normal trading range” has been created just as it has in crude oil.
GOLD AND OIL
We have attached charts representing the price action in Gold and Oil, two widely followed commodities. They are important to track simply because oil impacts the global economy so deeply and gold has often been a good place to hide in difficult markets. The chart of GLD, the ETF that tracks the price of gold and trades over 13 million shares per day indicates a recent loss of momentum. GLD closed on December 31, 2010 at 138.72 and after a minor correction in January stayed in a solid uptrend through July closing the month at 158.72. Once the equity volatility kicked in during August, Gold became an investment of choice for fearful investors along with U.S. Treasuries and GLD skyrocketed to 185.85 in early September. However, as the equity markets regained sound footing and rallied, GLD faded and has consolidated also even closing recently below its 200 day moving average for the first time in several years. Gold will be interesting to monitor as the potential pressure that may face the Euro Currency and the changing inflation/deflation structure could increase volatility in Gold.
Crude Oil has also been trading steady with a general upward pressure on price. In our view the previous decade saw crude trade in a range of $20 to $50 consistently unless war time fears sent it higher. Once the $50 was broken on the move to 140 in 2008, now a new range has developed in the $50 to $100 range. Recently it has been in the 90s and bumping up against that $100. There are many factors that could contribute to a move higher for crude oil and with ongoing unrest in the Mid East, a potentially new direction in U.S. foreign policy as the election looms and any tension between Israel and Iran etc. Clearly, the economy is fragile enough that a huge move higher in crude would likely destroy what little growth there may be.
OIH is the oil service ETF and we like to track and trade it. It is currently in a short term down trend and trades at $112 vs. a 2010 close at 140.53. Its 200 day moving average recently turned down too so we will continue to monitor these for trading setups.
EQUITY MARKETS
While all the previously mentioned areas impact investment opportunities, our favorite topic is always the equity market itself. With 2011 closing and likely at a slight loss for the year it is important to understand the overall market and map a good plan headed into 2012 which should hold its own challenges. Given the major challenges in the Euro zone, a weak growing economy, ongoing social unrest, we have experienced recent volatility. The market gyrations since late July have seemed extreme but a review of the actual numbers vs. historical, indicates volatility has been quite tame.
A review of intraday volatility measures the width of range each day from the day’s high to the day’s low. Obviously, a percentage must be used to accommodate the different quantitative values from year to year. This past year, 2011, was barely above 2010 in terms of intraday volatility and substantially below levels of 2008 and 2009. While 2008 was a very nasty bear market, the intraday volatility was also much higher in the late 90s and the topping year of 2000 was almost identical to 2008. We also track the number of days with 1% and 2% moves, both up or down. Again, the day to day volatility was pretty average and well below extreme volatility levels. Interestingly, major long term bottoms are almost always associated with high readings and wide volatility. The bottom line is it could get much more volatile moving forward but 2011 was pretty average.
While economic growth is expected to be muted there have been recent indications of improvement. The jobless claims recently dropped to a multi-year low and this indicator is usually rising as the economy enters a recession. The ISM increased recently and remains near the important 50 level, but is showing improvement. The U.S. Leading Economic Index just made a new high and Consumer Confidence made a large jump in late November. Overall, the data points indicate the U.S. will avoid a double dip or a new recession but it may not feel like it as growth will be light.
Technically the market remains mixed with a bias to the weak side. One of the key technical indicators we utilize is breadth. This measurement of the Advance-Decline line is helpful in both short term trading and long term market analysis. It has held up better than the equity indexes during 2011. It is much closer to highs than lows but is in a consolidation mode, much like most of the indexes. This will bear watching to see if the AD line can breakout to new highs and potentially signal or confirm a move higher. Also, one of our proprietary indicators that measures Accumulation and Distribution is near a key buy point. Again, we must be patient and wait on the actual confirmation but this may help determine if the selling recorded since late July was the start of a new bear market or simply a severe correction in the bull market that began in March 2009.
A review of the chart for the S&P 500 Index (SPX) shows that the summer selling was intense and did major technical damage to stocks. The important 200 day moving average turned down in September and the index has yet to have three consecutive closes above this key long term moving average. It has acted as resistance on several rally attempts. Should the SPX clear its 200 DMA and then take out the October high of 1292.66 it still has a great deal of overhead resistance. The entire first half of 2011 was spent trading between 1370 and 1250 on the SPX. It is significant that 1250 was major support during the first part of 2011 and has been major resistance recently.
The Russell 2000 is also consolidating below a down sloping 200 DMA and will have a great deal of resistance to chew through on rally attempts. The Dow Jones Industrial Average (DJIA) is a more advanced recovery pattern. Time will tell if this is the DJIA leading or simply the result of defensive investors fleeing to safety during a difficult market period. The DJIA has cleared its 200 DMA which is moving sideways.
The fundamental picture remains solid as valuations are not stretched especially for such a low rate environment. The operating earnings of the Standard and Poors 500 Index, (SPX) are estimated at 97.26 for 2011 and 107.3 for 2012. While we believe 104 is a more likely outcome for 2012 the PE Ratio is only 11.37 times the current 2012 estimates. This is a low multiple when you consider the dividend yield is 2.3%, the 10 year U.S. Treasury is below 2.0% and the 30 year U.S. Treasury is barely over 3.0%. With interest rates set to remain quite low into the future, we would expect the PE ratio to be more likely to increase moving forward.
Should SPX earnings hit the 104 level and the PE ratio increase to a reasonable 14 this would project the SPX to 1456 which is some 16.5% higher than today’s levels. Since 1988 the median PE has been approximately 18, and since 1936 it has been 15.7, both much higher than current levels. Also, since 1954, the yield on the 10-year U.S. Treasury note was above 7% before PE ratios traded below the 10.6 area. We believe a solid case can be made for both a rise in earnings for SPX companies and an increase in the historically low PE multiple.
The November through April six month period is typically the best for stock market returns. Since 1945, the SPX has risen by 6.8% on average during this six month timeframe. The other six month period of May through October has only increased by 1.2% on average indicating that we currently reside in the best period from a seasonality standpoint. October, 2011 was a huge up month and there is some evidence that the bear move (down +/- 20% in most indexes) ended even though we have yet to get a long term buy signal from our proprietary timing model.
Since 1945 there have been four corrections in the 15% to 20% range and four mild bear markets (20%-25%). The market reaction after these 8 pullbacks has been an explosive move to the upside. The SPX rose by an average of 13.5% during the first three months after these corrections. In the six months that followed the average gain was 23% and after a full 12 months the SPX grew by 31.7%. As professional traders and investors we do not “anticipate the anticipators”. Even in a challenging market that we currently face we expect our time tested short term indicators and long term timing model to guide us through and it has yet to signal that it is time to buy aggressively. However, it does appear that the stage is potentially set for a more positive market in 2012.
GOOD TRADING
Darrell L. Jones dti
423-595-5483
