The major market indices finished the week with moderate gains. Trading was volatile as a snapback rally early in the week was pared by sharp declines on Thursday and Friday. We believe the pullback late in the week reflected buyer's fatigue and concerns about potential headwinds to the global economic recovery.
The market is likely to enter into a period of price discovery over the next few weeks as investors digest recent events and try to gauge what is currently priced in the markets and what is likely to come to fruition. While a choppy, sideways trading pattern may play out in the near-term, the favourable macro fundamentals (improving economy, attractive valuation, robust earnings growth) in the United States, as well as bullish intermediate technicals, should continue to set the stage for additional market gains over the medium term.
Fighting debt with debt? Global stock markets rallied strongly in the early part of the week in reaction to an almost $1-trillion emergency aid package geared toward the sovereign debt crisis in Europe. The rescue package was much larger than most expected and was structured to prevent the crisis from becoming a full-fledged credit market contagion. While the package was applauded by the global markets, the question remains whether Greece and the other heavily indebted European countries will have the fortitude to follow through with the tough austerity measures (i.e. tax increases, wage cuts, etc.) that are being imposed. In addition, the aid package is basically being structured as a lending facility. Therefore, one has to wonder whether lending money to already over-borrowed countries will fix the problems or is akin to giving a junkie the keys to a pharmacy.
While the lending facilities and the loan guarantees will likely provide a near-term backstop, they do little in the way of addressing the fiscal and economic issues in the region. In addition, there is a possibility that the rescue fund will create an environment of "moral hazard," leaving indebted countries with little incentive to implement tough fiscal programs.
| Index | Closing Price 5/10/2010 |
Week Ending 5/15/2010 |
Year to date through 5/15/2010 |
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| Dow Jones Industrial Average | 10,620.16 | 2.31% | 2.69% | ||
| Wilshire 5000 Total Market | 11,770.17 | 2.69% | 3.05% | ||
| S&P 500 | 1,135.68 | 2.23% | 1.85% | ||
| NASDAQ Composite | 2,346.85 | 3.58% | 3.42% | ||
| S&P/TSX Composite | 12,014.97 | 2.76% | 2.29% | ||
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Uncertainty = Volatility. The uncertainty surrounding the situation in Europe has led to an uptick in volatility. While the CBOE Volatility Index (aka the "fear index") has doubled since mid-April, the swing in intraday prices is also notable. Over the past two weeks, the difference between the daily high and low of the Dow Jones Industrial Average has surged to an average 302 points. This compares to an average of 135 points since the beginning of this year.
Gold hits new high. Gold has a tendency to benefit during times of financial stress as well as when inflation expectations are on the rise. Both factors have come into play recently as uncertainty surrounding the state of the monetary union has led to a plunge in the value of the euro. This, in turn, has resulted in an increased appetite to own tangible assets like gold. One of the unintended consequences of the debt issues in Europe is that most global central banks will likely have to keep interest rates lower, longer. This is fuelling fears that the influx of fiscal programs being implemented in Europe could result in an uptick in inflationary pressure. From a political point of view, it may be hard to raise rates to combat inflation when the wheels are falling off the wagon.
As an aside and a potential prelude to a near-term top in gold prices, it was reported last week that a hotel in Abu Dhabi has recently installed an ATM-like machine that allows for the exchange of paper money for gold coins and bars. While gold will likely trend higher for the foreseeable future, news stories like this tend be a caution flag and indication of building frothiness.
Oil declines. The building concern over the strength of the global recovery has weighed on oil prices recently. After peaking at almost US$87 per barrel in early April, oil finished the week at US$71.85 per barrel. According to weekly statistics from the U.S. Department of Energy, oil inventories have risen in 14 out of the last 15 weeks, a sign of waning demand.
This was also the reason the International Energy Agency lowered its global oil demand forecast for 2010. The agency now estimates daily demand at 86.4 million barrels, a reduction of 220,000 barrels per day. In addition, because oil is priced in U.S. dollars, the recent strength in the greenback is making crude more expensive for foreign buyers.
China enters bear market. Also weighing on sentiment last week was the fact that the Chinese market, as measured by the Shanghai Composite Index, has corrected by over 20% from the highs reached in November and has officially moved back into bear market status (a bear market is defined by a 20% reversal from a prior peak). The weakness in China reflects the ongoing efforts by policy makers to slow growth through stricter lending policies.
The Chinese markets are considered a leading indicator, as they were able to bottom well ahead of the rest of the global benchmarks. The Shanghai's underperformance and the threat of slower growth seems to be another factor in the recent bout of global market weakness. The concerns seem to reflect the potential ripple-effect of slowing growth in China and how it could impact the fragile recoveries that many other economies are still navigating.
Q1 earnings summary. As of Friday, 460 members of the S&P 500 have reported first-quarter results, with 77.1% beating analysts' expectations. This is well ahead of the normal 61% beat rate. Overall earnings are up 55% and well ahead of the estimate for 35% growth coming into the quarter. In addition, revenue growth is coming in well ahead of analysts' expectations, suggesting that the better-than-expected trend in earnings is not just a product of cost-cutting initiatives. On the sector level, nine of the 10 S&P sector groups have posted positive year-over-year gains, with only telecom (-2.3%) showing a loss.
