Friday, October 17, 2014

Dow Gains 290 Points as Bulls Battle Back, Small Caps Lag

We knew today was going to start off well for stocks, but did anyone imagine it could be this good?

Agence France-Presse/Getty Images

The Dow Jones Industrial Average has gained 294.35 points, or 1.8%, to 16,411.59 at 1:05 p.m. today, while the S&P 500 has risen 1.5% to 1,894.40 and the Nasdaq Composite has advanced 1.4% to 4,275.04.

Why is the market rising? Why not? There are always the comments from the Fed's James Bullard, who that bond buying could continue if the data warranted it. Then there’s the data itself, which has been heartening. Today, for instance, the University of Michigan’s consumer confidence index rose to 86.4, well above expectations for a dip to 84.

Sure, good data hasn’t always been good news recently. Still, it’s another sign that the U.S. economy has been able to weather a slowdown in Europe. A conviction that that would be the case spurred the folks at Northern Trust to lighten up on developed markets like Europe and Japan and put the money into US stocks. They explain:

This month we downgraded our outlook for economic growth for the developed economies outside the United States, as we think the path to easier fiscal policy and structural reform in Europe will be a long road. Even though there's been some moderation in surveys on U.S. growth, the all-important labor market is delivering noninflationary growth. Job growth, along with new job openings, has been strong in the last month, while overall wage gains remain stuck at 2%. The recent rally in the U.S. dollar will prove a headwind to export-related sales, but the decline in energy prices this year will provide an offsetting boost to the broad economy. The U.S. economy remains the least export dependent of the major developed countries.

Increased uncertainty around the global growth outlook has led to an uptick in market volatility, resulting in the first 5% decline in the S&P 500 in 32 weeks, as compared to a typical length of just 10 weeks. In a relatively short period, market sentiment has turned cautious, with the Chicago Board Options Exchange put/call ratio reaching its second highest level of the past 12 months. Market indicators like this show that the market may be oversold near term, but a sustainable rally will likely require evidence of continued expansion of the U.S. and Chinese economies. We expect this to happen during the next year.

The one worrisome detail today: The small-company Russell 2000 has gained just 0.2% to 1,088.43 despite outperforming all week. Credit Suisse strategist Lori Calvasina says the “jury’s still out” on small caps:

Small cap investors [are] eager to call a bottom: The top questions we have received in recent weeks are whether small caps are cheap, whether they cheap are relative to large, and whether the small cap underperformance cycle vs. large cap is over.

Small caps no longer expensive, but not cheap either: In absolute terms, the R2000 is back to a favorable range and its long-term average on forward P/E, but still looks expensive on price/sales. Small/large relative fwd P/E & price/sales multiples are back down to LT averages and make the best argument for a bottom in the small/large relative trade.

We are getting more neutral on small vs. large, but view more bullish calls that the inflection is at hand as a bit premature. We have upgraded the valuation from negative to neutral in our 6 DRIVERs framework, but still see more negatives (Investor Sentiment, Economic Indicators, Retail Money Flows) than positives (Deals). Beyond increased confidence on these, an extension of stimulus from the Fed might cause us to get more constructive.

And isn’t that what this rally is all about?

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