MarketView for November 2

 

 

Summary 

 

In anticipation of a blowout victory by Republicans, Wall Street began to celebrate early with a substantial rally that sent all three major equity indexes into positive territory early in the trading day, and for the most part those gains held through the day until the closing bell. Most polls show Republicans regaining control of the House of Representatives, while President Barack Obama's Democrats could be left with a narrow majority in the Senate.

 

Nonetheless, the word on the Street is that we could likely be facing a strong selloff in the days ahead as the ebullience of the election begins to fade. The S&P 500 index is up approximately 14 percent since September on speculation of Republican congressional gains and new measures by the Federal Reserve to stimulate the economy.

 

A divided Congress is typically seen as bullish for stocks as it makes passing new laws harder and lessens uncertainty for business. Healthcare stocks, which were under pressure before the healthcare bill became law in March, climbed in Tuesday's session. Cigna closed up 4.2 percent to $36.85. Some of the healthcare law's critics hope Republicans can spearhead attempts to repeal or not fund parts of the law.

 

Energy stocks were the second best performer among the 10 S&P sectors, rising 1.1 percent. Republicans, traditional supporters of the oil industry, are viewed as less likely to pursue regulations that would hurt profits. A rise of 1.1 percent in oil prices on Tuesday also helped the sector.

 

In what could be another positive catalyst for stocks, the Fed is expected to announce a program of asset purchases of at least $500 billion via quantitative easing -- in effect printing money to buy bonds and lower borrowing costs. A statement is expected on Wednesday after a two-day meeting.

 

The dollar fell 0.7 percent against a basket of currencies. The dollar and the S&P 500 have established a close inverse correlation in recent weeks. The 30-day correlation currently stands at -0.84, with -1 being a perfect inverse correlation.

 

In earnings news, MasterCard rose 2.9 percent to $245.98 after it reported third-quarter earnings that exceeded expectations. However, Kellogg ended the day down 2.2 percent to close at $49.63 after its latest guidance indicated weaker-than-expected earnings growth in 2011.

 

The CBOE Volatility Index .VIX, Wall Street's favorite barometer of investors' fear, slid 1.2 percent after six days of gains. Volume was light, with about 6.92 billion shares traded on the New York Stock Exchange, the American Stock Exchange and Nasdaq. The year-to-date daily average is 8.73 billion shares.

 

Fed Ready to Try Again

 

The Federal Reserve, beginning a two-day meeting on Tuesday, appeared ready to try and increase economic activity even as many question whether the Fed’s plan to add about $500 billion of liquidity might do more harm than good. The meeting is widely expected to end with a controversial decision to buy hundreds of billions of dollars Treasury debt to try to foster a stronger recovery.

 

Policymakers are disappointed the unemployment rate is stuck at 9.6 percent and are worried a deflationary spiral could emerge, with core inflation already running at lows not seen since the 1960s. They hope fresh purchases of government bonds will lower borrowing costs and spur spending. However, many economists -- and some Fed officials -- warn the impact could be minimal and some worry the program, which has sparked a vigorous debate at the central bank, risks rampant inflation down the road.

 

"When you get interest rates as low as they are, they can't go much lower, so I don't look for any overpowering results of this action," former Fed Chairman Paul Volcker said.

 

Financial markets have been anxiously awaiting the impending decision, which is expected around 2:15 p.m. on Wednesday. Since Fed Chairman Ben Bernanke first hinted at a new round of asset purchases in August, the Standard & Poor's 500 index has gained about 14 percent, while bond yields have plumbed lows not seen since the depths of the financial crisis.

 

Stocks have also been supported by expectations that Republicans, viewed as more pro-business by investors, will seize control of the House of Representatives and pick up Senate seats in Tuesday's elections, which were largely cast as a referendum on the economy.

 

The Fed has already purchased about $1.7 trillion of government debt and mortgage-linked bonds. The expectation now is that the next round of Treasury purchases will be about $500 billion over a six-month period, with the program left open-ended to allow the Fed to add another round of purchases if needed.

 

The anticipated easing has weakened the dollar. The Australian dollar hit a 28-year high against the dollar on Tuesday after a surprise rate hike from Australia's central bank, which underscored the uneven nature of the global recovery.

 

With the prospect of a long period of ultra-low returns in the United States, investors have flocked to emerging markets, pushing those currencies higher. Emerging economies, worried about a loss of export competitiveness, have cried foul.

 

The Bank of Japan, which meets on Thursday and Friday, is also poised to launch a new round of bond buying. The European Central Bank and Bank of England also meet this week, but their positions are unlikely to change.

 

The economy grew at a modest 2 percent annual rate in the third quarter, a bit stronger than in the prior three months but too weak to make a dent in unemployment. Meanwhile, inflation is well below the Fed's preferred range of between 1.7 percent and 2 percent. In the third quarter, core inflation, which strips out volatile food and energy prices to give a better view of the underlying trend, rose at a 0.8 percent annual rate, the second-slowest pace since 1962.

 

With 14.8 million Americans unemployed and factories operating well short of full capacity, some Fed officials see the risk of a vicious circle of deferred purchases and falling prices that could choke off economic growth. Bernanke laid the groundwork for a further round of bond purchases by arguing the central bank was falling short of its twin objectives -- price stability and full employment.

 

Further bond purchases, however, are a controversial subject at the central bank and a heated debate seems assured. The Fed owns roughly 12.5 percent of all outstanding Treasury bonds and notes. If it were to buy $1 trillion more, as some economists expect it eventually will, the portion of its holdings compared with all outstanding Treasuries could increase by about 27 percent.

 

Some policymakers are concerned that additional purchases could jeopardize the central bank's credibility if the impact proves small. There are also concerns the Fed's bloated balance sheet may set the stage for unwanted inflation once the recovery gains traction.

 

Kansas City Fed President Thomas Hoenig, who is concerned the Fed's easy money policies are prelude to yet another boom and bust cycle, said on October 25 that further easing would be "a bargain ... with the devil."

 

Options Market is Wary

 

In a week of great uncertainty, with the announcement of a massive Federal Reserve buying program widely expected and the jobs report for October due, options traders have become more defensive as they await the unknown. The most familiar measure of investor anxiety, the CBOE Volatility Index .VIX, has moved higher for the past six days. Nonetheless, the actual volatility in the S&P 500 index is at its lowest point since April.

 

The results of the U.S. midterm elections on Tuesday, the size and scope of the anticipated Fed Treasury-buying program and the U.S. employment report at the end of the week all could dictate the market's tone for the rest of the year and into 2011. In other words, expectations for a more market-friendly outcome, meaning less regulation and enforcement of current regulations, has helped the rally grow deep roots. The S&P 500 is up 12.9 percent since the end of August. At the same time there is a distinct possibility of a rather sharp sell-off as the ebullience wears thin.

 

Optimism over the election outcome and the Fed meeting has driven the stock market in the last two months. But additional nervousness has accompanied the rally. Implied volatility normally falls as stocks rise, but this is not a typical period. The VIX closed at 21.83 on Monday, the highest in a month. The index is up 16.2 percent while the S&P rose only 0.1 percent over the past six days, a sign of worry that a sell-off could ensue in coming weeks. But as the VIX nudged higher, realized volatility, which measures past daily ups-and-downs in the S&P 500, has fallen dramatically. The divergence bodes ill for stocks in the near term.

 

However, Goldman Sachs equity derivatives strategists wrote in a report to clients that realized volatility often remains low around the election. In the six elections since 1950 that resulted in a change of congressional control, realized volatility averaged 11 for the three months after the election.

 

Goldman strategists recommend hedging for those who are fully invested and have participated in the recent market rally. "In a scenario where the market pulls back minus 2.5 percent by market close Wednesday, the optimal hedge is buying SPX November 1,125 puts for $6.60," Goldman wrote.