February 2012 Market Update

The rally continues

February continued January’s strong market performance. The S&P 500 Index was up another 4.32 percent, for a year-to-date return of 9 percent, while the Dow Jones Industrial Average climbed 2.89 percent. This was the best February market performance since 1998.

Equity markets continued to enjoy strong technical support during the month. All three major indices remained above their 200- and 50-day moving averages. The S&P 500 blew through the 1,350 resistance level we identified last month and is making an attempt to break the next resistance level of around 1,370. On a sector basis, information technology and energy led the pack while materials and utilities lagged.

International markets performed even better than domestic investments, with the MSCI EAFE Index up 5.74 percent and the MSCI Emerging Markets Free Index up 5.89 percent. The significant steps taken in Europe to reduce the risk of the sovereign debt crisis there have clearly comforted investors. Fears of a hard landing in China have also eased. The EAFE joined the emerging markets index in moving above its 200-day moving average, and a positive technical trend is clearly in place in both.

The Federal Reserve stands pat

In February, the Federal Reserve (Fed) reiterated its commitment to maintaining sustained low rates but appeared unwilling to enact additional easing in the near term. Yields for 10-year government bonds remained at historically low levels, fluctuating around 2 percent, and the Barclays Capital Aggregate Bond Index declined 0.02 percent over the month. Bond investors have continued to demonstrate a cautious outlook, despite improving economic fundamentals, and do not appear to share the optimism of equity investors (see the chart below).

Source: Bloomberg

The dominant drivers of the Treasury market remain both Fed policy and the perceived risk levels associated with other assets. If fears continue to recede, Treasuries may begin to come under some selling pressure. Historically, when new unemployment claims drop to around where they are now, the Fed has raised rates within the next 18 months. Although the current environment differs from previous periods, bond investors might be well-served to keep this historical correlation in mind.

Municipals continued to perform well in February, with yields falling across the short end of the curve and investment inflows remaining strong. Municipals were supported by improvements to the health of state and local balance sheets, with Bloomberg reporting that state tax revenues increased at their fastest pace since 2006.

Mixed economic signals

February saw continued improvement in the employment situation, with weekly initial jobless claims fluctuating around 350,000 and January’s unemployment rate declining to 8.3 percent. Demand for new employees has been widespread across industries and particularly strong for small- to medium-sized businesses. These changes in the jobs situation did not go unnoticed. Consumer confidence rose to levels not seen since February 2011, as respondents became more optimistic about business conditions and the labor market.

On the other side of the coin, housing has continued to be an economic drag. According to Case-Shiller data, home prices fell 0.5 percent in December 2011. Sales data has been somewhat better, but downward revisions have shown that transaction levels remain depressed. Prices have increased in some regional markets, however, and housing affordability is near peak levels.

Equity markets appear to be pricing in a rebound in housing in 2012. Now that the banking industry has resolved outstanding lawsuits over improperly processed loans, the only remaining risk is that foreclosures could increase as the year progresses. Data from early spring will likely be telling, as this is typically a time of increased housing demand.

American manufacturing and industry continue to demonstrate signs of growth. February marked the 31st consecutive month of manufacturing expansion, according to the Institute of Supply Management Index. Recent data, however, has implied slightly less robust growth levels than in the previous two months.

Oil and gasoline prices rise

Oil and gasoline prices rose significantly in February, due to a combination of supply constraints and an increased risk premium. The U.S. sanctions program on Iran has constrained supply from that country. Supply disruptions in Syria, Libya, and Sudan, resulting from civil conflicts, have also been significant. The combined effect has tightened oil output, and, although other producers are attempting to make up the difference, they do not appear to have been completely successful.

Perhaps more significantly, growing tensions in the Middle East have caused a risk premium to be baked into the price of oil. Rhetoric between Iran and Israel has become increasingly hostile, as Israel has threatened to make a preemptive strike against Iran’s nuclear program. In the event of an attack, Iran has pledged to close the Strait of Hormuz, an action that could drive oil prices considerably higher. Higher oil and gasoline prices are among the most significant risks for both markets and the world economy in 2012.

Europe—two steps forward

Substantial progress seems to have been made on the European crisis. The most recent Greek bailout was successfully passed and now awaits implementation. Although real obstacles remain in the execution, the train is on the track. Additionally, the European Central Bank’s (ECB) Long-Term Refinancing Option (LTRO) program has significantly relieved concerns about banking system liquidity. These two factors have been key contributors to the trend of improving investor outlooks.

Despite the good news, continued risks still exist in Europe. One major issue that remains is the pending process of standardizing fiscal practices across the European Union. Political backlash in peripheral countries against austerity measures could grow going forward, even as governments rely on the ECB and core European nations for financial support. The situation remains uncertain, and substantial risks remain.

A strong start but continued uncertainty

Markets had a very strong start to the year, and many economic indicators have been surprisingly positive, but uncertainty remains. In the U.S., investors will monitor consumer spending and manufacturing data closely. European debt issues remain a risk as well. Nevertheless, though volatility can be expected to persist, the global outlook is showing signs of improvement.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Free Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.

Authored by Brad McMillan, vice president, chief investment officer, at Commonwealth Financial Network.

© 2012 Commonwealth Financial Network®

Commonwealth Financial Network

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