UBS Wealth Management Research: Midterm 2010: The Wave Breaks

Finding the Middle Ground

Polling stations had not even closed in many congressional districts and yet the outcome of the midterm elections was already long decided. In our pre-election report, we likened these elections to a “rogue wave” that was about to crest. Well, that wave has now broken and, as expected, it broke in a decidedly Republican manner. Although some contests are still deemed “too close to call,” the makeup of the 112th Congress is now clearly defined with Republicans having recaptured control of the House with a fairly commanding majority, while Democrats managed to hold on to the Senate with a narrow majority.

Although the results fell pretty much in line with projections, the election did feature some surprises and even some upsets along the way. The failure to capture a majority of the three special election seats in the Senate, the inability to unseat Senate Majority Leader Harry Reid (D-NV) and the loss of
the State House in California were all disappointments for the Grand Old Party (GOP). Meanwhile, Democrats were likely unnerved by the depth of the losses sustained in the House, where a number of long-serving senior lawmakers were swept out in the Republican tidal wave.

But now that the election has been decided comes the really tricky part: trying to determine which issues the new Congress will work together on in this emotionally charged partisan atmosphere where the two parties are more ideologically divided than ever. Republicans have made no secret of their disdain for some of the legislative initiatives passed during the last  session of Congress, especially health care reform, and have publicly lobbied for repeal. Democrats, on the other hand, have dug in their heels over ey spending initiatives and social programs that they deem critical to their principal constituents. This makes for a challenging environment in whichthe middle ground will be harder to find and political battles will be pitched.

Still, there are some issues that require Congress to work together. Neither party wants to be held responsible for inaction on a wide range of critical initiatives, such as tax policy, trade issues and regulatory relief. Republicans can no longer afford to sit on the sidelines, and Democrats will need to understand that bipartisanship cuts both ways if the 112th Congress is tomeet with any success.

Post dramatic stress syndrome

The lead up to these midterm elections was about as dramatic as any in recent memory. Both parties spent record amounts of money for a non-presidential election year, bombarding likely voters with television ads, phone calls, lawn signs and rallies. Democratic and Republican leaders alike imploredtheir party bases to turn out for an election they categorized as critical to the future of the nation. And these efforts appear to have paid off, as a number of congressional voting districts recorded voter turnouts that exceeded the levels seen during the last presidential election. But now that the election has been settled, the more important, but mundane, task of governing a nation begins anew. The decisions made in this new Congress will have important implications for both the real economy and financial markets.

It is, therefore, important to focus upon just how the 112th Congress will impact policy decisions, growth prospects and asset class returns. Although it is difficult to draw definitive conclusions before the new Congress has even been seated, our team of economists, strategists and analysts have taken a first crack at it.

Raymond James Investment Strategy Jeffrey Saut, Chief Investment Strategist, Nov. 8, 2010

"Everybody’s Happy!?"

. . . “Money managers are unhappy because 70% of them are lagging the S&P 500 and see the end of another quarter approaching. Economists are unhappy because they do not know what to believe; this month’s forecast of a strong economy or last month’s forecast of a weak economy. Technicians are unhappy because the market refuses to correct, and gets more and more extended. Foreigners are unhappy because due to their underinvested status in the U.S., they have missed the biggest double play in decades. The public is unhappy because they just plain missed out on the party after being scared into cash after the crash. It almost seems ungrateful for so many to be unhappy about a market that has done so well . . . Unhappy people would prefer the market to correct to allow them to buy and feel happy, which is
just the reason for a further rise. Frustrating the majority is the market’s primary goal.”
. . . Robert J. Farrell

Bob Farrell was Merrill Lynch’s esteemed strategist for decades. He penned the aforementioned comments in September of 1989 after the D-J Industrial Average (DJIA) had risen from that year’s January price of 2100 to its September high of 2791 without any meaningful correction. Accordingly, those investors waiting for a pullback to “buy” were frustrated. Similarly, present-day investors are pretty frustrated as the DJIA has leaped from its August “low” of ~9940 into last Friday’s high of 11451 without any significant
correction. The recent “Buying Stampede” began on September 1st with a 255-point Dow Wow and has continued for the past 47 sessions without anything more than a one- to three-day pause/correction before resuming the onslaught. The latest upside skein has eclipsed the 38-session march into the August 1987 “highs” that preceded the crash, as well as the longest “Buying Stampede” chronicled in my notes of some 40 years. Over the decades I have come to trust my “day count” indicator because it has worked so well. As stated in past comments, it is rare for a “Buying Stampede” to extend for more than 30 sessions. That is why I wrongfootedly turned cautious, but not bearish, on day 33 of the stampede (October 18th) with the DJIA at ~11159.

Since then, the senior index has still not experienced anything more than a one- to three-day pause/correction; yet, has also not really moved significantly above the October 18th intra-day high, that is until last Thursday’s 220-point Dow Delight.

Indeed, last Thursday’s triumph broke the DJIA (11444.08), as well as the D-J Transportation Average (DJTA/4923.40), above their respective Spring reaction highs of 11205.03 and 4806.10 respectively, thus rendering another Dow Theory “buy signal.” That signal reconfirmed the Dow Theory “Buy signal” I wrote about last July and continues to suggest the trend of the stock market is bullish.

Still, Thursday’s session failed to qualify as another 90% Upside Day because while Points Gained exceed the 90% threshold, Up Volume didn’t, coming in at 89.3% of total Up/Down Volume. Nevertheless, since the late-June “lows” there have been ten 90% Upside Days, accompanied by strong Advance-Decline readings, reflecting the durability of this rally. In fact, the New York Composite Advance-Decline Line is well above its April rally peak and Lowry’s Buying Power Index has risen to a new rally high, while the Selling Pressure Index tagged a new reaction low, late last week. All of this only reinforces my view that any correction will be shallow and brief.

The explosive rally from the June “lows” has lifted the DJIA by some 16%. Meanwhile, the Dollar Index ($USD/76.76) has surrendered roughly 16% from its respective June high into its recent low, causing one savvy seer to exclaim, “Are stocks really going up, or is the measuring stick going down?!” Clearly, that is a valid question. Yet, my sense is the U.S. dollar “sell short” trade is getting profoundly crowded. To wit, I was on a number of TV shows last week where other pundits were beating the greenback like a rented mule. Most of their comments centered on the statement, “the dollar is worthless,” to which I replied, “If so, why don’t you send them to me!” To be sure, while I too am a long-term dollar bear, I think the dollar’s dive is long of tooth and believe it to be near a short/intermediate-term inflection point. Verily, I am confident the Dollar Index will not violate its 2008 “lows” located  between 71 and 73, at least in the short/intermediate-term. If correct, a reversal in the dollar’s misfortunes might imply a pause/correction for my beloved “stuff stocks.” Inferentially, both of those thoughts gained traction over the weekend since
Barron’s cover story was, “China’s Sure Bet.” The byline read, “With the dollar vulnerable, China for the first time is investing more overseas in hard assets, like copper, oil and iron, than in U.S. government bonds.”

Plainly, last week’s two major events were the mid-term elections and the Fed’s announcement of another quantitative easing (QE2). Both went pretty much as expected. While many negative nabobs think QE2 will not work, I think it will work better thanexpected. It should be effective at lowering real interest rates, which should improve the fiscal funding metrics. QE2 should also lower people’s propensity to save (read: spend money). The risk is that countries like China may view QE2 as a maneuver designed to get them to revalue their currency upward relative to the U.S. dollar. In fact, last Thursday China, Brazil, and Germany criticized QE2, while a number of Asian central banks announced intentions to defend their currencies. For further color on QE2, please read our economist’s (Dr. Scott Brown) comments attached to this report.

As for the mid-terms, I have argued for months that if the Republicans regained the House, and came close to taking back the Senate, President Obama might just pull a Clinton and move to the “center.” I further evinced if that happens the S&P 500 (SPX/1125.85) would likely cross above 1300 quickly. And last Wednesday a clearly contrite President showed signs of becoming more centrist. Meanwhile, last week’s economic reports continued to come in better than expected with 13 of them above estimates, five weaker, and three on target. The same is true of corporate earnings and revenue reports. More importantly,
companies are guiding 4Q10 earnings estimates higher. So again I say, to an underinvested portfolio manager (PM) the current environment is a nightmare! And that, ladies and gentlemen, is why any correction should be short and shallow as underinvested PMs will be forced to buy the “dips” in order to keep up with the Joneses (aka, the Dow Joneses). Indeed, focused on 2010’s yearend, PMs have performance risk, bonus risk, and ultimately job risk by underperforming the major market averages.

Summing the parts, I continue to have a timid trading stance in large part due to my day-count sequence, the overbought nature of most of the indices, and the fact that many of the indexes have spiked above their respective upper Bollinger Bands (rare occurrence). That said, I am not afraid to buy select stocks. Over the past few weeks my preferred strategy has been to buy fundamentally sound companies, with unbroken business models, when they have had a price concession for a one-off reason. On
October 14th that’s exactly what happened to NII Holdings (NIHD/$42.73/Strong Buy) when the Televisa deal was called off. On that announcement NIHD shares fell more than seven points in a day and we recommended purchase, as noted in our Investment Strategy report of October 18th. On October 26th a number of announcements caused Lexmark’s shares (LXK/$39.19/Outperform) to collapse 10 points in a day and our analyst recommended purchase in a written comment that same day, as we noted in our verbal
strategy commentary that Tuesday. I think such a strategy takes much of the “price risk” out of the investment equation and I continue to invest, and trade, accordingly.

Barclays Capital Research - Global Economic Weekly for Nov. 8

Loose policy and solid growth should buoy markets

The first indications of global activity in Q4 were stronger than expected.

We view the slowdown in Q3 as a transition to a more sustainable pace of growth and not the start of renewed stagnation.

Global monetary conditions, which were already highly supportive, have been loosened further.

The combination of firm economic data and abundant global liquidity should support risky asset prices.

Developed Economies

United States: The Fed eases as the economy turns stronger

As expected, the Fed this week launched an incremental and open-ended asset purchase program.

Euro area:  Bank lending shows signs of improving

In most cases euro area bank lending is expanding across countries, with the aggregate held back by non-financial lending in Ireland, Spain, Germany and Belgium.

UK: QE2 is not assured

We expect that next week’s Inflation Report will not signal that QE2 is imminent.

Japan: BoJ quiet, but prepares for contingencies

The BoJ kept the market on its toes by rescheduling its mid-November MPM for this week, but a muted reaction to the FOMC allowed it to focus on its stated objective.

Emerging Markets
China: The need to normalise monetary conditions

We look for CPI inflation to rise to 4.1% in October from 3.6% previously, and think another interest rate hike before year-end is needed to anchor inflation expectation.

Emerging Asia (ex-China): Headed for a pause
The Reserve Bank of India raised both the repo and reverse repo rates by 25bp, but hinted at no further rate hikes in the near term.

EMEA: Tricky inflation and shaky growth but strong IP3

Strong PMI readings this week indicate the IP sector will continue to underpin the EMEA recovery. Price pressure is a potential side effect, as output approaches full capacity.

Latin America: Flocking together

On the back of thought-through arguments, as well as seemingly more instinctive reactions, central banks in the region have grown increasingly dovish.


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