Tread Carefully Even as Stocks Run

Stocks Reach a Two-Month High

U.S. stocks posted strong gains last week, hitting their highest level since mid-August. The tech-heavy Nasdaq Composite Index led the pack, climbing 3.41% to close the week at 5,031, while the Dow Jones Industrial Average grew 2.50% to 17,646, and the S&P 500 Index was up 2.07% to 2,075. Meanwhile, the yield on the 10-year Treasury rose from 2.03% to 2.09%, as bond prices fell.

As stocks continue their advance, we see an ongoing trend toward more differentiation. In this environment, we continue to be cautious on momentum names and see the best opportunities in technology and, outside of the U.S., European equities.

Central Banks and Earnings Help Stocks

Several factors helped drive the strong performance of stocks. While third quarter earnings have been roughly in line with estimates — approximately 50% of companies have beaten consensus estimates — several marquee names have been turning in better-than-expected numbers. This is particularly true in technology, where standouts include eBay, Amazon, Google and Texas Instruments. We have also witnessed another round of mergers, with two large transactions in tech: Lam Research agreeing to buy KLA-Tencor for $10.6 billion and Western Digital acquiring SanDisk for $19 billion.

The big winners last week were European equities. This should come as no surprise, given the focus on the European Central Bank (ECB). Namely, the week was punctuated by comments from ECB President Mario Draghi that the bank may extend its current quantitative easing (QE) program past September 2016 as it awaits signs of a "sustained adjustment" in inflation. Stocks in Europe rallied as the euro fell to a two-month low against the dollar. A broader measure of European stocks was up 5% on the week, while German equities were up around 7% with cyclicals leading the advance.

Expect More Gains, But Leadership Is Shifting

Despite prospects for a modest acceleration in growth, monetary accommodation, both in and outside the United States, can probably carry markets through year's end. That said, investors need to take note of a few trends.

First, investors are growing increasingly choosy. Evidence of this can be seen in the surge in large price moves related to earnings announcements. The number of instances where a stock price moves up or down by 10% or more following an earnings announcement is much higher this quarter than in recent years.

Second, the possibility of more QE from Europe may turn out to be a mixed blessing. While QE in Europe was one catalyst for U.S. stocks' rally, the positive reaction was somewhat ironic given the recent pressure a strong dollar has put on U.S. corporate earnings.

Third, leadership among sectors is shifting. Health care, the previous leader, is now struggling. U.S. health care stocks have rebounded from their recent lows, but are now underperforming the broader market even as other defensive sectors, notably utilities and consumer staples, perform well.

Finally, investors need to take note of falling expectations for 2016 earnings. While analysts expect better than 9% earnings-per-share growth in 2016, estimates have been declining. To the extent that economic growth remains modest, U.S. companies, with already high profit margins, will struggle to grow earnings.

So heading into the end of the year, we are focused on areas where earnings growth may be easier to come by in a slow-growth world. We continue to favor technology, which is up around 6.5% year-to-date, comfortably outperforming the broader market. We believe this can continue. We also maintain our preference for European equities, which can continue to benefit from more monetary accommodation and a stabilizing economy. The only caveat, given our expectation for more QE and a soft euro: Consider strategies employing a hedge against some or all of the foreign currency exposure.

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