Stocks Are Taking A Breather from the Rally

October 2, 2012

The primary positive factor underlying equities appears to be the concerted actions of central banks to help stabilize the global financial system. So far this year, the positive forces have been winning out, but to many, the rally in risk assets is looking tired.
-Bob Doll, senior advisor, BlackRock

Markets Advance Pauses

After being flat to slightly down two weeks ago, stocks declined last week, with the Dow Jones Industrial Average falling 1.1% to 13,737, the S&P 500 Index dropping 1.3% to 1,440 and the Nasdaq Composite slipping 2.0% to 3,116.

To at least some extent, the pause in the rally we have seen over the past couple of weeks can be attributed to some profit-taking on the heels of a significant multi-month uptrend (US stocks rose close to 6% in the third quarter). It is also likely, however, that investors are coming to grips with the fact that the world continues to face some serious risks and are recognizing that not all of the world's problems can be solved by central bank action.

Economic Growth Likely to Remain Muted

Economic data was mixed last week. On the negative side, second-quarter gross domestic product growth was revised lower from 1.7% to 1.3%, confirming that the United States was in the midst of a soft patch earlier in the year. The big positive surprise, however, was the much-larger-than-expected increase in consumer confidence (likely helped by rising home prices). Higher levels of confidence are critical in terms of driving longer-term growth, since they can promote gains in consumer spending, which, in turn, can lead to better jobs growth, creating a self-reinforcing cycle.

There are still some significant drags on economic growth, including a weak jobs market, only modest levels of capital spending by companies, uncertainty about the political and fiscal future of the United States, and concerns about growth in Europe and China. Despite the headwinds, our guess is that the US economy should be able to grow somewhere around 2% for the foreseeable future. The drag from housing has turned into some positive movement; private sector jobs creation will continue (if slowly) and consumer spending should be steady to the upside at a slow pace.

Outside of the United States, we believe the ongoing European debt crisis will continue to exert strong deflationary pressure on the global economy. The programs launched by the European Central Bank should help contain the crisis, but will not do much in terms of promoting economic growth. We expect that Chinese growth may bottom in the fourth quarter, but any upturn will be modest since the eurozone crisis has cut deep into Chinese export markets.

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