October Optimism Could Help Overcome November Losses

Includes: DIA, QQQ, SPY
by: Julie Young

Pre-election gains could help U.S. markets end positive in 2012. Year-to-date through October the Dow Jones Industrial Average gained 9.51 percent. The Dow Jones U.S. Index had year-to-date gains of 14.18 percent. Financials led the U.S. market with the Dow Jones U.S. Financials Index gaining 22.36 percent year-to-date through October.

Gains through the first 10 months of the year were fueled by positive U.S. economic data, positive earnings estimates and improving consumer sentiment.

Two key economic indicators, gross domestic product and employment, showed positive readings in October. Third-quarter gross domestic product estimates from the Bureau of Economic Analysis stated an increase of 2 percent. The 2 percent increase added to 12 consecutive prior increases in the quarterly gross domestic product measure.

October's Employment Situation report was also positive, stating an increase of 171,000 non-farm payroll jobs with an upward revision to nonfarm payrolls in August and September. Meanwhile, the unemployment rate increased slightly to 7.9 percent but still remained below 8 percent for a second consecutive month, a level it had not seen since January 2009, when it began its upward climb.

Consumer sentiment measured by the Thomson Reuters/University of Michigan Consumer Sentiment Index (pdf), also improved in October. According to the survey, consumer confidence reached a five-year high as consumers expressed increased optimism about their personal finances and the outlook for post-election reform.

October monthly returns began to price in the market's risks, which included uncertainty on third-quarter earnings, the election and the fiscal cliff. In October the Dow Jones Industrial Average lost 2.39 percent. The Dow Jones U.S. Index lost 1.71 percent. Eight of the 10 Dow Jones U.S. Index sectors were down in October with the greatest losses occurring in the Technology and Telecommunications sectors, which were down 7.35 percent and 4.12 percent, respectively. Financials led the total market in October gaining 1.38 percent, followed by Utilities, which added 1.24 percent.

Despite the month's losses, year-to-date returns remained strong and consumers remained optimistic.

Consumers' optimism helped to improve spending in turn improving third-quarter earnings for companies in the Dow Jones Industrial Average.

Third quarter earnings data from Bloomberg shows 23 of the 29 Dow 30 company earnings releases reporting earnings per share that met or exceeded analysts' expectations for the quarter. This indicates management's transparency in earnings reporting, which further indicates public information factored into stock price valuations. Earnings growth forecasts are weaker in 2013 compared with 2012, according to Morningstar data, but the third-quarter earnings transparency appears to keep stock values at their current levels for the near term, which could help markets finish strong in 2012.

In November, markets have been bypassing the positive underlying data to focus on the effects of the fiscal cliff. Current month-to-date returns in November for the Dow Jones Industrial Average have fallen 4.31 percent with all U.S. Dow Jones sectors down, ranging from a loss of 2.12 percent for the Dow Jones U.S. Consumer Goods sector to 7.45 percent for the Dow Jones U.S. Utilities sector.

Fiscal cliff debates appear to be the final hurdle for U.S. equity markets in 2012. Assuming any solution is achieved before the year-end deadline for automatic tax increases and spending reductions, positive year-to-date underlying data and third-quarter corporate earnings reports could propel markets to finish up for the year and give them positive trajectory for 2013.

In a recent Wall Street Journalreport, Ed Yardeni of Yardeni Research, Inc. articulated his positive outlook on the economy if the fiscal cliff is avoided.

If the fiscal cliff is averted in the U.S., prospects for the U.S. economy are reasonably good in 2013, said Yardeni.

Given a year-end fiscal cliff resolution scenario, investors locked in to equity investments can hope for gains. Investors in the middle class can currently plan on extended tax breaks given President Obama's initial urging in current congressional discussions. If legislation is immediately passed as currently proposed by President Obama, middle-class investors earning below $250,000 per year would see minimal changes to their 2013 tax rates. Given that middle-class consumers comprise the majority of retail market investors, this scenario would likely ease erratic market trading and help to price in the market's more positive factors.

Investors earning above the $250,000 per year income level can now bet on increased tax rates given the post-election results and current discussions. These investors are likely to seek tax-sheltered investments such as municipal bonds and tax-managed funds, as they await new tax reform for 2013.

Given the positive underlying data and currently proposed middle-class tax break extension scenario, markets could overcome November losses and finish 2012 with sound gains.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.