Stocks: Too far, too fast?

Equity markets have sprinted out of the blocks. The S&P 500 returned 5% last month, the best start to a year since 1997. The worst-performing sector of the market, technology, was up 1.3%, translating to an annualized gain of 17%. Needless to say, this performance prompts the question as to whether this pace is sustainable. We suggest that it isn't likely, which probably isn't a stretch prognostication, given that the annualized return for the aforementioned S&P 500 would be 78.5%. Market participants have spent much of the past few years fretting about the big macroeconomic risks, such as Europe's unsettled sovereign-debt issues, China's slowing growth, and heightened political rancor at home. Now the concern is that markets have entered a danger zone because excessive fears about the risks of the day have been replaced by an unusual degree of complacency. The Chicago Board Options Exchange Market Volatility Index, otherwise known as the “fear gauge,” usually lifts if anxiety levels are high, yet the index has fallen to its lowest reading since 2007. Does that mean that there is nothing to worry about? No. But it does suggest that though a correction in the stock market may be overdue, it seems unlikely to be very damaging in the absence of an unforeseen deterioration in the economic environment. On that note, let's look at a few data points that offer evidence that the landscape isn't showing signs of slipping but rather conditions are improving. One, of course, is the stock market itself. The market is a discounting mechanism that usually reflects the collective interpretation by investors of events expected six to nine months hence. Therefore, its rise can be interpreted as a view that things are improving, both domestically and globally. Another is The Conference Board Leading Economic Index, a composite of economic factors, including weekly hours worked, jobless claims, manufacturing orders, housing permits, interest rates and consumer expectations. The monthly report is instructive, as it reflects directional biases and turning points in the economy. Today the LEI is rising, having expanded 0.5% last month. We use other snapshots to support our view further. The first shows the recovery in housing prices. The S&P/Case-Shiller Home Price Indices, which capture information from 20 major metropolitan markets, rose 0.6% in November alone. Home prices are now up 5.5% on a year-over-year basis through November, the biggest yearly gain since August 2006. That bodes well for consumer spending, as the wealth effect from housing's contribution to household net worth tends to lead to increased consumption. Since personal consumption drives 71% of the U.S. economy, a wealthier consumer signals better economic growth. The others are reports issued by the Institute of Supply Management, covering the manufacturing sector and the services industries. Together, they represent the activity of the domestic business community at large. Levels on these charts above 50 indicate an expansion, while below that a contraction. Both show readings that are clearly in expansion modality and a pattern of having been in this phase for some time. The net of it all is that while stocks have performed well so far this year, it wouldn't be a surprise to encounter a period of price weakness. However, in a world of moderate economic growth, low inflation, accommodative liquidity, undemanding valuations and negative real interest rates, stocks remain poised to deliver good returns. As we believe the cyclical uptrend is intact, we recommend staying with an overweight equity position, favoring sectors such as energy, technology and select financials. We also advocate diversifying to international markets where good values can be found, namely Europe, or in countries and regions that are growing at a multiple to that of growth in the United States, such as emerging Asia, and specifically China. Mark Luschini is the chief investment strategist for Janney Montgomery Scott LLC.