Equity Strategy Weekly
Stuart T. Freeman, CFA, Chief Equity Strategist
Scott L. Wren, Senior Equity Strategist
Market fireworks possible, economic fireworks less likely
On the economic front, we do not see many upside surprises. Slow improvement. No spectacular
fireworks over the next 12 months, in our opinion. Just grinding it out. We are expecting a continuation
of the weak recovery through the end of this year and all of 2013. But stocks can work their way higher
in a modest growth/modest inflation environment.
Please see page 4 of this report for Disclaimers
Page 1 of 4
August was a slow period for the market with the
S&P 500 trapped in a narrow trading range for the
last three weeks of the month. September was a
bit more exciting with a bit of back and forth but
still not offering many chances to do any portfolio
maneuvering. For the most part, either you were
positioned to take advantage of the advance or
you were not. The only decision was whether or
not you wanted to jump on board. Still, after
rallying more than 4% on the month at one point,
the market ended up 2.4% in September. Not bad
by any measure.
But now we are entering October, which on
average has been a positive month for the S&P
500 over the last 60 years. The market has had
positive momentum for most of the last four
months with only one noticeable pullback along the
way. It is a Presidential election year and most
polls are within the margin of error or show the
incumbent with the lead. European problems are
not going away any time soon and headlines could
cross the tape at any time. The “fiscal cliff” looms
but market participants seem convinced that the
can will be kicked down the road for at least six or
12 months. Tensions between Iran and Israel are
still building with many predicting an outbreak of
hostilities in coming months. The Chinese
economy is stumbling. In other words, there are
many things going on around the globe, which
could impact the U.S. stock market suddenly
without any notice.
Any or all of the above issues could produce
headlines that come back to jolt the stock market
at any time. The VIX (a measure of expected
market volatility) is below 17 and, in our opinion,
showing a more complacent attitude toward the
market than is likely deserved.
But the economy tends to ebb and flow with fewer
surprises than the stock market. Human emotion
often grips the stock market for periods of time but
it usually takes something more drastic to change
the course of the economy and it generally
happens over a longer period of time.
On the economic front, we do not see many upside
surprises. Slow improvement. No spectacular
fireworks over the next 12 months, in our opinion.
Just grinding it out. We are expecting a
continuation of the weak recovery through this
year and all of 2013. Growth this year will likely
be well below trend in the 2% area and not much
better next year. The modest growth versus most
recovery periods will probably continue. This
recovery has offered half the growth of the
average of the last 10. We do not expect that to
change in the next handful of quarters. Net
lending is up from the lows but still well below the
levels of the last decade. Our work with leading
indicators points toward broader growth across
segments of the economy over the next 12
months.
Given all the liquidity being pumped into the
financial system at home and abroad, some
market pundits fear inflation. We see only modest
inflation over the next 12-plus months. Wage
growth continues to be minimal, demand for credit
is low, unemployment remains high and there is
plenty of spare manufacturing capacity both in the
U.S. and abroad.
Our current work continues to suggest that our
2012 earnings estimate of $103 is appropriate.
This represents approximately 6%-7% growth for
the full year. We expect the slow comparisons of
this year’s second quarter to continue into the
Equity Strategy Weekly October 2, 2012
Page 2 of 4
current quarter. We foresee earnings of $108 for
next year, representing an increase of slightly less
than 5%. The market is currently trading at
approximately 13.4x our 2013 estimate, well below
the long-term average. Our work suggests the
potential for a higher S&P 500 level one year out
versus the recent 1445 level.
Our sector weightings reflect a more cyclical view
in portfolio positioning. We expect cyclicallysensitive
sectors such as Consumer Discretionary
and Materials to have another bout of
outperformance during the balance of this
economic recovery. We not only expect a higher
market over the next year but also better breadth
across industries within the general market.
In addition to the Materials and Consumer
Discretionary sectors, we also recommend an
overweight in Technology and Telecom Services.
Our underweight recommendations include Energy,
Financials, Health Care and Utilities.
The world is a very uncertain place. We expect
stock market volatility to increase as we move
through the end of this year and into 2013.
However, we see a continuing lift and broadening
in economic fundamentals, better consumer
confidence and increased spending growth. We
look for further forward progress in job growth and
some catch-up in investor confidence. If the
leading indicators for the European economy show
a pickup by early 2013, we would anticipate that
our earnings estimate for next year may prove to
be too conservative. Investors should not count
out the possibility for additional forms of easing
from numerous major central banks around the
world. Global easy money policies will be here for
a while.
Weekly wrap and look ahead
All three major indices lost ground in last week’s
trading. The S&P 500 dipped 1.3% (year-to-date
[YTD] up 14.6%), the Dow Industrials fell 1.0%
(YTD up 10.0%) and the NASDAQ Composite
dropped 2.0% (YTD up 19.6%). Looking at S&P
sector performance, five of 10 outperformed the
index but only one managed to gain ground on the
week. The best performing sectors were Utilities
(up 0.9%), Health Care (down 0.3%) and
Consumer Staples (down 0.6%). The worst
performing sectors were Information Technology
(down 2.4%), Materials (down 1.9%) and
Financials (down 1.6%).
A mixed bag of economic data last week took a
minimal toll on the major market averages as the
Fed continues to “have the market’s back” as does
every other major central bank around the world it
seems. Despite a host of poor economic data and
the likely lack of meaningful improvement in
growth over the next 12 months, the market
continues to hover near multi-year highs.
Good news last week came from the housing
market and confidence/sentiment readings. The
Case/Shiller Home Price Index showed a second
consecutive month of year-over-year
improvement, gaining 1.2% versus expectations
for a 0.6% advance. Many of the areas in this 20-
city index were among the hardest hit in the
housing crash (Las Vegas, Miami, Detroit, etc.).
After the slow improvement in this index, housing
prices are now down 30% from their all-time highs
(mid-2006). Pricing is also improving in the new
home segment of the market, beating expectations
in August. The sales volume of new homes came
in slightly below market projections but is well
above the lows seen in early 2011.
Consumer confidence, as measured by the
Conference Board, also came in better than
expected last week as the future expectations
portion of the survey beat estimates. Survey
participants felt better about the forward outlook
for stocks and the labor market. Higher gasoline
prices, at least at this point, have not had much of
an impact. It was a similar situation with the
University of Michigan’s consumer sentiment
survey. The current situation reading is not great
but there is more optimism about the future. We
continue to believe a better labor market is what
will ultimately be necessary to drive
confidence/sentiment to levels normally associated
with a “good” economy. Confidence on both the
business and consumer fronts is key , in our
opinion, to getting the U.S. economy up and
running at an average speed or better.
More mixed news came from the latest revision to
second quarter gross domestic product (GDP) and
from the personal income and spending data. The
latest second quarter GDP revision was released
last week and fell well short of estimates. GDP
growth (annualized) in the second quarter was
revised down to 1.3% (actually 1.25% before
rounding) from the previous 1.7% level. The
average economist was not looking for a change
from the prior reading. It is tough to make quick
progress on the labor front with growth this slow.
But, we are looking for improvement in the
quarters ahead. This year’s economic growth
should be in the 2% range with something near
2.5% next year, which is still below the longerterm
average.
Equity Strategy Weekly October 2, 2012
Page 3 of 4
Personal incomes are not rising much (0.1%) but
spending increased 0.5% in August. Adjusted for
inflation, incomes were actually down. As a result,
the savings rate fell. Given the high level of
unemployment and abundance of cheap labor
abroad, it is unlikely that overall wages will climb
by any meaningful amount over the next several
quarters at least. It is a supply versus demand
situation and right now there is an oversupply of
workers available. That translates into almost zero
wage pressure in most industries.
With the headlines likely slowing out of Europe
over the next few days, investors will be paying
attention to the first Presidential debate on
Wednesday night and Friday’s release of the
September employment data. Putting politics
aside, labor data is critical right now and has huge
potential to move the market if the actual result is
much different than expectations. Currently, the
consensus is looking for approximately 120,000
net new non-farm payroll jobs to have been
created last month. The unemployment rate is
expected to tick up to 8.2% compared to the
current 8.1% rate. The labor market is slowly
improving but many millions remain unemployed
or underemployed. The labor participation rate is
at a 30-year low. Those who have stopped looking
for jobs and dropped out of the labor market are
not counted in the official employment statistics
(since they are not considered to be “in” the labor
force). Needless to say, the absolute number of
people employed in the U.S. is well below the
height achieved in the last decade. This problem is
not going to solve itself any time soon and may be
more structural than cyclical.
Other data on the agenda includes manufacturing
and services segment surveys from the Institute
for Supply Management (ISM), vehicle sales,
factory orders and consumer credit. The ISM
surveys hold much sway with investors and traders
and have been hovering near the 50 mark for quite
a while. With these surveys, readings above 50
indicate expansion while anything below shows
contraction. The manufacturing survey was below
50 in August and is expected to still be in the
contraction zone in the September reading. The
services segment survey should come in near 53
when released on Wednesday. Vehicle sales
should continue to be good with annualized sales
in the 14 to 15 million unit range when reported on
Monday. With the average age of a car on the
road in the United States being more than 10
years, replacement has become necessary not just
desirable. Other data should be more reflective of
the slow growth environment that we expect.
Equity Strategy Weekly October 2, 2012
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©2012 Wells Fargo Advisors, LLC. All rights reserved. 1012-00335
Page 4 of 4
Disclaimers
An index is not managed and is unavailable for direct investment.
There is no assurance that any target price mentioned will be attained.
Technology and Internet-related stocks, especially of smaller, less-seasoned companies, tend to be more
volatile than the overall market.
Wells Fargo Advisors is a trade name of certain broker/dealer affiliates of Wells Fargo & Company; other
broker/dealer affiliates of Wells Fargo & Company may have differing opinions than those expressed in
this report. Contact your financial advisor if you would like copies of additional reports.
Additional information available upon request. Past performance is not a guide to future performance.
The material contained herein has been prepared from sources and data we believe to be reliable but we
make no guarantee as to its accuracy or completeness. This material is published solely for informational
purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or
investment product.
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