THE MARKETS
Following a 215-point gain on Monday, the Dow ran out of gas as it gave back all of the gains by the close on Thursday. But the party wasn’t over as a late 100 plus point spurt on Friday extended the rally to its third straight week. For the week, the Dow Jones Industrial Average gained 121 points (+1.5%) and ended another volatile period at 8443. The NASDAQ fared a lot better as it added 44 points (+3.4%) and settled at 1331.
The question at this junction is whether this latest rally is the start of something big or simply another round of short covering. The markets have now tested 7300 on the Dow Jones Industrial Average twice and have held, forming a solid base on which to build. Regardless of whether the final test of that bottom has been made, there is increasing evidence which points to a sustained (but volatile) 2-3 year bull market.
Third-quarter earnings estimates are starting to roll in, and the market has responded positively, in part because the numbers haven’t been as bad as the earnings warning season may have indicated. Companies in industries ranging from autos (General Motors) to healthcare (Abbott Labs) to financial services (Citigroup) and even to technology (Unisys) are making their numbers, albeit while indicating that conditions remain tough.
Previously dire forecasts appear forgotten amid the rally of the past week. However, unless sales growth starts to accelerate, thereby improving the quality of overall corporate profit growth, the recent pattern may be repeated: a sharp sell-off heading into the corporate reporting season, followed by a relief rally as profits are reported. The strength in the economy is not broad enough to sustain the current rally much beyond the 950-1000 level in the S&P 500.
THE COMPASS PORTFOLIOS
A quick reversal in several of the indicators has restored half positions in many portfolios. The trading range on the Dow has been between 7300 and 9000, and the downgrades we acted upon earlier this month came in response to testing the bottom once again. If the trading pattern continues, we believe a retest of the upper part of the range may be in order. Missing that potential move is undesirable, and so we believe cautious buying is certainly warranted. We will be quick to act on a reversal if necessary, but we believe there exists greater upside potential than downside risk between now and the end of the year. Our preference is to eventually remain fully invested, assuming the markets cooperate. We continue to be responsive to the terrifically volatile market, and we continue to believe that America’s best days lie ahead.
I’ve had some really great conversations with many Appleton Group clients as we continue our quarterly reviews. Opinions about the state of the market have been quite varied, but a tone of resilience and optimism can definitely be heard. While all clients voice strongly the desire to manage investment risk, many have expressed a willingness to retest quality investments in anticipation of a better fourth quarter. So far, the markets are responding nicely, and our portfolios are beginning to see some very nice gains. Our goal, as always, will be to capture as much of the gains as possible, and to continue to manage risk should the markets falter.
THE ECONOMY
In the U.S., most of the recent rhetoric from the Federal Reserve suggests that the majority of voters on the Federal Open Market Committee, the Fed’s policy-setting arm, believe the Fed has done enough to stimulate economic growth (it sees its current policy as “accommodative”) and deem the economy’s long-term prospects as healthy. U.S. financial markets appear to have come around to that view in mid-October. Equity prices have recovered some 15% from their recent lows, and the yield on the benchmark 10-year Treasury note has shot up nearly 40 basis points, to 4.11%.
Recent U.S. data reports certainly support that view. One leading example: the 13.3% surge in September housing starts. But while homebuyers remain resolute, caution persists elsewhere, especially in Corporate America. Take a look at one business sentiment indicator, the Philadelphia Fed index. This widely followed gauge of regional business conditions fell to -13.1 in September from 2.3 in the previous month, reflecting still-sour corporate sentiment.
While home sales could be robust for another month or so, the recent rise in mortgage rates could temper the pace. In contrast with Friday’s Durable Goods Orders report, these upbeat sales numbers for new and existing homes support our view of a moderate and protracted recovery with the Fed on hold.
Before the markets opened on Friday, the Commerce Department said durable goods orders to U.S. factories for September dropped 5.9 percent, the biggest decline since November. Economists had expected a drop of 1.9 percent, according to Briefing.com.
