Stocks' Strong Start to 2013 Continues but...

The stock market rally that began the year continued last week, as the Dow Jones Industrial Average climbed 0.4%, the S&P 500 Index advanced 0.4% to 1,472 and the Nasdaq Composite rose 0.8% to 3,125. After only two weeks, US stocks are up between 3% and 3.5% for the year. European stocks have posted similar gains and equities in Japan have advanced even further.

The question that clearly arises from all of this is whether or not the equity rally will continue. For the year as a whole, we would expect equity markets to continue to advance and to outperform bonds, with the best performance likely coming in emerging markets. That said, however, we expect the current pace of gains to slow—if not immediately, then probably by February.

There are several reasons to be at least somewhat more cautious in the near term. First, we expect a good deal of headline risk coming in the next couple of months. Investors should expect continued dysfunction from Washington as lawmakers wrestle with the debt ceiling, scheduled spending cuts and the need for continuing budget resolutions. Not only are the odds of some sort of "grand bargain" diminishing, but the current bickering raises the possibility of another last-minute showdown and a potential debt downgrade. There is also political risk coming out of Europe, with Italian elections coming up in February. Should the election fail to produce a clear result, or should the voters choose a less market-friendly government than the one currently headed by Prime Minister Mario Monti, markets would likely react negatively.

The bottom line is that while we think stocks are reasonably valued (particularly outside the United States), we would expect tougher going as we head into February.

Outside of the political risks, we do have some lingering concerns about the economy. Once we get a look at January month-end data, we will see the first clues about how higher taxes are impacting the economy. Notwithstanding some of the stronger data we cited earlier, we are expecting the first quarter to show relatively soft economic data. In particular, we are concerned about consumption levels weakening in January as people come to grips with smaller paychecks.

We would also point out that although these risks are clearly evident, investors seem to be overly complacent. One way this can be measured is by looking at market volatility. The VIX Index (a widely followed measure of stock market volatility that is also known as the "fear index"), fell last week to its lowest level since June 2007. To us, this suggests that there is not much bad news priced into market right now, meaning that any negative shock would have the potential to drive markets lower. The bottom line is that while we think stocks are reasonably valued (particularly outside the United States), we would expect tougher going as we head into February.

Source:  Russ Koesterich, BlackRock Global Chief Investment Strategist

The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

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