Investors Cheering For A Strong Finish; They Might Get Their Way

Includes: DIA, QQQ, SPY
by: Phillip L. Clark

Autumn weather has arrived as it does every year about this time. You can feel a certain change in the air and foliage begins to show nature's truest colors. It isn't uncommon to hear folks chattering about this perfect time of year, but like most things in life, this tranquil scene is transitory. With the presidential election only a month away, American's will spend their time missing the ephemeral outdoor splendor in order to focus on superfluous debates and political disputes. Some things never change; thankfully this [debates] only occurs every four years.

Garnering more attention than fall colors, the now two week old unemployment report looked good on the surface. The ostensible reading is being scrutinized by both political parties; Democrats say the numbers are solid proof of an improving economy while Republicans maintain underemployment is growing. Regardless of political agendas, these surveys are based on small samples and the results are far from accurate. There is one irrefutable fact; unemployment is above normal and GDP is below normal. Turns out that the surprise drop in unemployment was somewhat anomalous rather than fact based on at least one large state's incomplete data. The rate change reflected an 873,000 spike in household employment versus a 368,000 drop during August.

For the first time since January 2009, the unemployment rate is below 8 percent. Government jobs are also on the rise again following a 45,000 jump in August. Assuming the numbers are real, what caused everyone to begin hiring? With 78% of the companies in the S&P 500 Index warning about further slowdowns, hiring would not be high on their priority list. Nevertheless, we noticed one statistic which has remained at all-time high levels - the average duration of unemployment. In September, the average duration of unemployment was 39.8 weeks, not far below the peak of 40.9 weeks reached in late 2011. This is not congruent with the Friday's job report.

The mixed data continues with manufacturing making a modest comeback, albeit slight. Moving from negative territory, the ISM Manufacturing Index rebounded to 51.5 in September from 49.6 in August. Once more, surface data can often lead to a flawed conclusion. The underlying and often cloaked negatives are a fourth straight month of contraction for new export orders (reflective of global slowing) and a sixth straight contraction in total backlog orders. The non-manufacturing report also moved up in September to signal further pick-up in the economy. Another big gain in the report was in business activity, which means that non-manufacturers are very busy filling orders. However, non-manufacturing is facing the same pressure of slowing export orders. The other misfortune is lack of motivation to hire.

Last, but certainly not least, we have reached the infamous Q3 earnings season. Investors are cheering for the typical strong finish to the trading year, in spite of the ever-looming fiscal cliff. But the stock market, entering the final furlong of the 2012 race, faces a number of headwinds that could slow its record finish. The election is a mere 21 days away and its ferocity is increasing with each passing day. But, before we can worry about political outcomes, markets will be challenged with what is expected to be one of the worst quarterly earnings seasons since late 2009. We have heard a number of warnings from heavyweights like Intel, FedEx, and Hewlett Packard. Satirical as it may sound, these heavyweights and many others lowered expectations heading into this earnings season; that universal perception could be the catalyst that drives stock prices higher.

Earnings season, as always, kicked off with Alcoa, followed by big banks JP Morgan Chase and Wells Fargo. Most of the earnings warnings have referenced Europe, but the big banks aren't facing much European impact. As of this writing, Goldman Sachs easily beat The Street and announced a dividend increase. China and the emerging economies play a role in the lowered Technology outlook that is further muddled by the structural change in how we process information (on tablets and smartphones, as opposed to PCs). With expectations set very low, better-than-anticipated guidance could be a plus; EPS misses will likely hit this market hard. EPS drama could become so intense that the election might sneak up on this ever bounding market. Stock prices partially retraced (by about 3%) in weeks following the QE3 announcement, but we reckon a stouter correction is needed to set up a true rally into year-end. This earnings season should go a long way in determining the next leg up; or down.

The Bottom Line: The latest economic news remains mixed--a common theme for a while, and one that may not change any time soon. Although the headline unemployment rate dropped notably (7.8%), payroll job growth slowed and hiring rates are not growing. Construction spending slowed, but housing seems to be continuing its uptrend due to record low interest rates. Nonresidential building has softened due to uncertainty over the languid economy and fiscal policy. Shortfalls at state and local government's have also weakened. What everyone calls a recovery is continuing but the pace is that of a snail.

Looking outside the U.S., East Asia growth forecasts were cut as The World Bank pointed to the potential for further slowdown in China. China's economy is expected to expand by 7.7 percent this year, down from a May estimate of 8.2 percent, while the growth forecast for 2013 was cut to 8.1 percent from an earlier 8.6 percent. Compared to the U.S., one might surmise that Asia is doing just fine. On the contrary, China's latest slowdown has been significant and some fear more of the same for a longer period than originally expected. Eurozone fears are once more dominating the headlines as austerity backlash was manifested in riots and higher financing costs (bond yields). We are watching their ongoing crisis closely as confidence and economic activity are undoubtedly being affected.

From a Technical Perspective, some deterioration has occurred in recent weeks; the number of stocks trading above their 50-day moving average is just 57 percent. Despite the ability of the U.S. stock market to reach the highest level since 2007, investors still appear to be in a defensive mood. Over the last week, for example, healthcare, utilities and staples were two of the market's strongest groups. Relative strength in these groups is rising and potentially sending a strong signal that investors are turning more nervous about the market's short-term direction. Small caps and technology are showing relative weakness; normally a sign of investor nervousness. In a normally strong and sustainable market, small caps and technology stocks rarely underperform.

The long term trend is still up as long as prices can hold above their 50-day moving average. Any move below that support line would cause concern. Breadth remains in solid territory though some weakening has been detected in recent days; approximately 57% are trading about their 50-day moving average. If investors are to get their wish for a strong year end finish, a healthy pullback just might do the trick. Looking to S&P 500 charts, strong support exists in the 1360-1390 range which means a 4-6% retracement.

We are confident that our portfolios are well-positioned for the upcoming earnings season; cash positions are higher than normal should a significant retracement occur though we expect any downturn to be limited; our exposure to stocks and bonds have provided risk adjusted returns above the S&P 500. Though we would like to be fully invested, rising headwinds, elections, and continued global slowing warrants a slightly more conservative approach. For now, weakness in the U.S. Dollar is should help stocks as we move towards year end. However, as foreign central bankers increase print in lockstep with the U.S., the dollar has a strong chance to outperform; that would be bad for stocks.

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.

Disclaimer: This information does not constitute a recommendation of any kind. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services.