Reduced risk for the rest of 2012

The absence of the regular daily triple-digit moves in the Dow that characterised 2011 to start the year has felt a bit strange to investors who were getting used to the elevated volatility.

However, recent action is more indicative of the way markets usually perform, and has contributed to nice equity gains so far in 2012. Additionally, it appears that at least some of the market attention has been taken off of the European debt crisis and we have seen some of the highly correlated, risk on/risk off trades that dominated recently dissipate.

An increased focus on the US, both at the economic and corporate levels, bodes well for the stockmarket’s potential to extend gains as we go through the year.

There remain risks, especially in Europe, but the willingness of the ECB to extend three-year loans to banks with very attractive conditions appears to have reduced the fear of a near-term financial disaster.

Caution and a well diversified portfolio are still in order as the future remains uncertain and US treasuries continue to trade near record low yields, indicating continued concern among investors.

Additionally, in the near term, a pullback could be in order. As we all know, nothing goes up in a straight line, and according to the Ned Davis Research Crowd Sentiment Poll, investor sentiment is creeping toward the extreme optimism zone, which is typically a near-term bearish indicator.

Another measure of sentiment – short interest on the New York Stock Exchange (NYSE) – is at the lowest point in a year, which could remove some of the fuel from a potential near-term rally. However, in spite of the recent improvement, both the Conference Board’s Consumer and CEO Confidence surveys remain in pessimistic territory, which have historically been strong contrarian indicators for stocks.

Overall, trust in the economy remains low but has improved slightly as the string of positive data continues to roll in. Manufacturing continues to lead the way, as the (NY) Empire Manufacturing index moved to a nine-month high, with both new orders and employment jumping.

Additionally, industrial production showed a nice 0.4 per cent gain, while capacity utilisation rose to 78.1 per cent but remained 2.3 per cent below its 1972-2010 average, indicating continued mild inflation over the next several months.

More encouraging news on the inflation front came as the producer price index (PPI) fell 0.1 per cent month-over-month (m/m). The consumer price index (CPI) was flat m/m and fell to a 3 per cent year-over-year (y/y) rate from 3.4 per cent. At the core level, which excludes food and energy, the CPI remained at a benign 2.2 per cent, and appears poised to head lower in the coming months.