A Healthy Rally?

The major stock market averages continued their gains last week. After advancing 10% in only 26 days, the S&P 500 reached a level not seen since September of 2008. The latest leg of the rally may be nearly exhausted after posting a double-digit gain in little more than a month. However, conditions remain favorable for growth. The LPL Financial Current Conditions Index, which monitors real-time conditions in the economy and markets, is at the highest level of the past year.

Our predicted path for the stock market (see the 2010 Outlook publication for details) is for a volatile, but upward-sloping market in the first half of 2010. This performance began to emerge late last year when after a powerful rally the S&P 500 pulled back 6% from October 19 – October 30. Following the pullback, stocks rallied back 11% from Oct 30 – Jan 19. This pattern of volatility around a rising trend was repeated from January 19 – February 8 as the S&P 500 experienced an 8% pullback and then rallied 10% from February 8 through last Wednesday, March 17. [Chart 1]

The ups and downs in the stock market have not been big daily swings.

Instead, the moves have unfolded over weeks or months. The daily moves have been relatively small and mostly in the same direction whether the market is going up or down. In fact, only five of the 26 days during the rally from February 8 – March 17 had daily moves bigger than 1% and none that reached 2%. We believe this type of multi-week, rather than daily, volatility is likely to continue.

Volatility on the brain

Another stock market pullback of 5 – 10% unfolding over a few weeks would not be unusual. There are a few reasons to question the health of the recent rally. Some technical indicators suggest the stock market is now overbought and recent gains have been on light trading volume, suggesting the buyers are becoming fewer. In addition, a potential catalyst for a pullback is that we are now entering the first quarter earnings pre-announcement season (where some companies provide guidance on how they fared during the quarter about a month ahead of their official earnings releases). It is worth noting that the last three 5 – 10% stock market pullbacks occurred leading into or during each of the last three earnings reporting seasons.

Pullback?

A catalyst for a pullback that may have weighed on the market late last week is the health care legislation that was passed in the House on Sunday, March 21. Within the Health Care sector the impact is mixed, the HMO industry is negatively impacted while the hospital companies, along with other beneficiaries of increasing health care volumes, benefit. However, much of this impact has already been priced in to the sector. Health Care sector investors are likely to be relieved that the period of uncertainty is now over.

The potentially negative outcome for the broader market stems from the tax and deficit impacts of the legislation. The legislation imposes a new 3.8% tax on investment income. This lowers the after-tax return on investments. It also adds a 0.9% tax on wages for those earning more than $250,000, set to take effect in 2013. Another macroeconomic impact is the potential to increase the deficit.
The bill establishes new insurance exchanges for the purchase of health insurance by those who do not have insurance offered through their employer. The bill caps the share of family income spent on health care premiums. Two important facts are necessary to understand the concern evident in the markets over the deficit impact of the legislation.

The average cost of a family health insurance policy offered by employers was $13,375 in 2009, according to the Kaiser Family Foundation and the Health Research & Educational Trust. On average, employees pay about 20% of premiums with the employer making up the rest (an average of $10,700 per employee).

Under the exchange, the taxpayers would subsidize the cost of a policy for individuals and families with incomes up to 400% of the poverty level. This means that a family of four with the national average income of about $70,000 (at 317% of the poverty level of about $22,000) would have their spending capped at 9.5% of income, which would be about $6,650. Taxpayers would pick up the other half of the cost of the insurance.

Congressional Budget Office

The Congressional Budget Office, the agency that tabulated the budget impact of the legislation, estimates that 18 million people would take advantage of the exchange to obtain subsidized health insurance. However, if employers that currently offer health insurance drop their coverage in order to save $8,700 per employee ($10,700 less the $2,000 penalty for employers with more than 50 employees that do not provide coverage) and shift that cost to the taxpayer, the number of people getting subsidized health insurance could surge well beyond the budgeted 18 million. After all, there are 127 million people with incomes between 150% and 400% of the federal poverty level. If a large percentage of these 127 million people were shifted to the exchange, with a typical annual subsidy around $5,000-$6,000, the annual cost of the legislation would soar and significantly worsen the budget deficit. While all of the potential effects of the health care legislation
are unknown, market participants are focusing on the risks.

Stocks slid on Thursday and Friday as the odds of passage for the health care legislation rose. The bond market did not benefit from the sell-off in stocks since a greater deficit is a negative for bonds. Instead, Treasury prices fell and pushed up the yield on the 10-year Treasury note modestly on Thursday and Friday.

While the passing of the uncertainty surrounding the health care legislation may be welcomed by investors, the wavering health of the rally and the passage of the health care legislation could combine to result in a pullback as the earnings season nears. However, healthy economic and profit growth are likely to limit the extent of any pullback as the markets continue to forge a volatile, but upward path.

IMPORTANT DISCLOSURES

  • The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
  • Stock investing involves risk including loss of principal.
  • Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
  • The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
  • There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.
  • Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
  • Health Care: Companies in two main industry groups: Health Care equipment and supplies or companies that provide health care-related services, including distributors of health care products, providers of basic health care services, and owners and operators of health care facilities and organizations. Companies primarily involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products.

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