Great Start

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The market is off to another great start. For the past several years we have seen an aggressive move higher in the early part of the year and then a sharp pullback. What does 2013 have in store for us? Let’s discuss what is driving this latest move higher and what has derailed things in the past few years.

Global growth trends are continuing to improve. Better than expected economic data in Europe and emerging Asia have led investors into areas of the market most leveraged to global growth, late-stage cyclicals. Globally, leading economic indicators are rising. The global growth trade is working. Economic surprises are accelerating outside of the U.S.  Chinese growth figures are exceeding expectations. China’s PMI recently hit a 19-month high. GDP in China is accelerating for the first time in two years. In response foreign markets are rising faster than our robust market.

Central bankers are also still fueling the current run in the markets. Our Fed is as accommodative as they can be. European central bankers have made it clear they will do all they can to keep the Eurozone out of a recession. The Bank of Japan announced essentially endless QE last week. So, money is cheap and growth is accelerating.

Fourth quarter earnings announcements have come in, for the most part, better than expected. Several companies in the industrial sector have announced earnings that have surprised to the upside. Perhaps more importantly they have given better than expected guidance. Many large U.S. industrial multi-nationals have announced robust growth in markets outside the U.S.  Chinese growth has been much better than modeled.

So, we have started another year with a mad dash to buy stocks. Investor sentiment has recently reached a multi-year high. Stan Weinstein summed things up this weekend as only he can, “The most bullish thing that the market can do is go up.”  Technically things continue to improve and people are willing to take on more risk.

What can derail things? Let’s look at what has put a wrench in the works the past few years and see if we can see a similar move in the market this year. We think that it isn’t all that useful to look at interest rates at this point. They are at historic lows and they have been low for quite some time. The key factor that has spurred the market higher and acted as a roadblock to prices at times is inflation. The rebound to growth in the global economy has been the fuel to the latest rally. As long as growth doesn’t heat up too much the markets will continue to work higher. But, too much of a good thing is rarely good.

By too much of a good thing I mean growth outside the U.S. that comes back to us in the form of higher prices. At a certain point surging growth outside the U.S. hits us all in the wallet. Higher inflationary trends eventually cause higher food and fuel prices. These are essentially real time tax hikes for all of us. These tax hikes cause our economy to cool and we see the markets sell off. Certainly the fiscal cliff and a variety of other large macro factors have influenced the markets over the past several years. There will be other macro factors this year also. But, I am going to continue to monitor fuel and food inflation here. In 2011 inflation had a large influence due to the impact of QE2. Last year lower inflation in the first half of 2012 gave a boost to consumer spending and helped the housing market in the second half of last year. We will see how things develop on the inflation front in 2013.

The technical picture of the market remains in great shape. 83% of the stocks in the S&P 500 are in basing or advancing patterns and 82% of stocks in the secondary markets are sound. These figures have been rising substantially for the past several weeks. There is a potential negative divergence developing. The S&P 500, Dow and Russell 2000 have all moved to new highs. The NASDAQ has not exceeded the 3200 level to make a new high. If this divergence is not taken out at some point during the week we could see a pullback in the market. Short term support levels for the S&P 500/Dow/NASDAQ/Russell 2000 are 1480/13,600/3110/890. The last few times the major averages have tested support levels buyers have come in and aggressively bought stocks. The current strength of the market leads me to believe that any pullbacks from these levels will remain controlled and orderly.

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About Thomas J Smith CFA