June 30, 2014
Massive optimism has lifted markets, however…
- Higher prices in the major stock market indexes mask internal weakness. Another near term break out, perhaps testing the 2,000-level on the S&P 500, could prove unsustainable. Caution is warranted.
- Mid-year weakness in the stock market is still a major concern for 2014, however, any correction occurring in the near-term should ultimately serve as a buying opportunity for the next leg of the secular bull market.
An abundance of new highs in the major stock market indexes have been accompanied with few signs of a major top (such as 2000, or 2007). To the contrary, signs point more assuredly to our long-term suggestion that the stock market remains in a secular bull market that likely has another decade to run. However, what the higher prices in the major stock market indexes do not show is that as the bull market ages, there are gradually fewer and fewer individual stocks holding up the major indexes.
- The percent of operating company only (OCO) stocks (stripping out things like preferred stocks and debt instruments) on the New York Stock Exchange (NYSE) rising to new 52-week highs peaked at 27.8% on May 15, 2013, fell to 24.9% on October 18, 2013, to 18.6% on March 4, 2014, and to just 13.2% on June 20th.
- The percent of NYSE OCO stocks down 20% or more from their 52-week highs was 12.2% on May 15, 2013, 13.0% on October 18, 2013, 14.1% on March 4, 2014, and 15.8% on June 20th.
From March 6th to now, trading volume has been dropping steadily, telling us that investors are refraining from buying despite recent stock market highs. Rallies that happen on diminishing volume are suspicious. Market internals suggest that another near term break out, perhaps testing the 2,000-level on the S&P 500, could prove unsustainable. The rally over the last few months has been frustrating, given that the prices of the indexes appear to be telling a different story than the foundation of the market, which is growing increasingly fragile. That said, with the failure of sellers to enter the market in any meaningful numbers, the market could rise higher on its continued slow grind. However (yes, another “however”) until internals (Demand, in particular) experience a material improvement, any further gains run the risk of evaporating rather quickly.
Mid-year weakness in the stock market is still a major concern for 2014, however (a good “however”), any correction occurring in the near-term should ultimately serve as a buying opportunity for the next leg of the secular bull market. While the path of least resistance appears to be higher for now, we maintain some concerns. Valuations, for example, are stretched. The price-to-earnings ratio is near the upper end of its historical range (excluding the tech bubble of the late 1990’s/early 2000’s). Consensus estimates for S&P 500 operating earnings per share (EPS) growth for 2014 have fallen from 13.3% as of December 31 to 11.5% currently, mostly due to revisions ahead of the first quarter 2014 earnings season. More downward revisions for quarters 2-4 are possible. The result would be that the forward looking price-to-earnings ratio, already at its highest level since May 2007, is understating valuation concerns.
Other obvious concerns include international crises, and very high levels of complacency regarding price volatility. The VIX Index (a measure of implied volatility of S&P 500 index options, or more simpler, a metric of sentiment toward expected stock market prices, aka the “fear gage”) has fallen to its lowest levels since February 2007. Like most sentiment indicators, we have found that the VIX has provided the timeliest signals after it has hit an extreme and reversed. The VIX has hit an extreme; it’s a matter of when, not if, the VIX will reverse – the message is that investors are getting optimistic enough that the stock market is susceptible to negative news.
And, of course, there is the concern of how quickly the Fed will taper and move toward raising short-term interest rates. The Fed should continue to be friendly on a historical relative basis, but a mid-2015 rate rise is possible, and that has stock market implications.
Bottom Line: The rally over the last few months has been frustrating, given that the prices of the indexes appear to be telling a different story than the foundation of the market, which is growing increasingly fragile. That said, with the failure of sellers to enter the market in any meaningful numbers, the market could rise higher on its continued slow grind. However, until market internals (Demand, in particular) experience a material improvement, any further gains run the risk of evaporating rather quickly.
Stock Market Sectors – Rate Hike Implications
- The Fed is not expected to raise interest rates for at least a year.
- Modest sector tilts may provide an edge in providing portfolio safety.
Although the first interest rate hike by the Federal Reserve is likely at least a year away, it is important to consider that stock market sectors anticipate this event well in advance. Leading up to an interest rate hike, the stock market typically performs fairly well, overall, for the year prior to the first Fed rate hike. That is to be expected, as interest rate hikes typically occur to curb already apparent excesses. The next rate hike occurs under a less normal condition (to grossly understate the situation). Historically, although all S&P 500 sectors have median double-digit rallies over the year prior to a rate hike, even under more ideal conditions nine out of ten S&P 500 sectors have double-digit drawdowns over that time.
The historical summation for the year prior to a rate hike is as follows: The best performing sectors (in terms of average gain and number of times outperforming the overall market) are Energy, Technology, and Industrials; the worst are Utilities and Financials.
The biggest swing in terms of moving from favorable to unfavorable, and vice versa, is Energy and Financials. Energy stocks have outperformed the S&P 500 in 7 of 8 cases in the year leading up to a first Fed rate hike, going back to 1977. (Inflation expectations have been basing recently, adding tailwinds to Energy.) Financial stocks have outperformed in only 2 of 8 cases over the same period, as the short-term end of the yield curve typically rises quickest, negatively affecting net interest margins of banks. Curiously, current year median earnings growth expectations for Energy (+8.6%) have been rising in recent months, but falling for Financials (-3.6%).
Bottom Line: The Fed is expected to raise rates sometime in 2015. While the stock market typically does well during the year prior to that event. Nonetheless, although all S&P 500 sectors have median double-digit rallies over the year prior to a rate hike, even under more ideal conditions nine out of ten S&P 500 sectors have double-digit drawdowns over that time. Modest sector tilts may provide an edge in providing portfolio safety.
Global Economic Outlook
- World economic activity is strengthening after a soft start to the year.
- Easing fiscal drag and improving credit conditions will support growth in developed nations.
- Improving global demand, weaker currencies, and moderate fiscal stimulus will support emerging economies.
- The European Central Bank (ECB) has announced a package that is expected to firm economic growth in the Euro Zone.
Global economic activity has been subpar since the start of the year, but growth will quicken in the second half as pent-up demand begins to propel the US economy and as the Euro Zone gains traction. Both the US and Europe underperformed in the opening months of the year and sluggish global demand has weighed on emerging market economies, including Asia’s export-facing manufacturers and South America’s resource producers.
The Euro Zone barely grew in the first quarter, and US GDP actually contracted, dragged down by a large drawdown in inventories and weather-related disruptions to business spending. But now, forward-looking economic data point to a strengthening global economy, and continued positive momentum. The OECD Composite Leading Indicator (CLI), a proxy for future global growth, was unchanged in April, following four straight declines. The stabilization in the CLI suggests the stage has been set for a better second half of the year. The steadying of the CLI is confirmed by improving Purchasing Manager Index reports. The global economy will strengthen through the second half of 2014, expanding into 2015.
There was Bernankenomics in the US. Then Abenomics in Japan. Now there is Draghinomics for Europe. (Mario Draghi is the president of the European Central Bank.) The classical monetary consensus that central bankers’ mandate started and ended with price stability died half decade ago. The list of tools used by central bankers now include exchange rates, stock prices, credit allocation, home ownership rates, mortgage activity, and whatever else that can be thought of.
On June 5th, Mr. Draghi announced a package of tools the ECB would employ to stimulate economic growth. The ECB opted to cut interest rates to a new record low of 0.15%, and imposed a negative deposit rate on the region’s commercial banks in an attempt to encourage banks to lend. Draghinomics correctly addresses the root of the European deflationary spiral: bank’s preference for buying government bonds over making “real economy” loans. The complete stimulus package marks a new era for monetary policy in the Euro Zone, and profoundly changes the investment outlook for the region.
The difference between Draghinomics and the better known Bernankenomics is that the ECB has been reluctant to use its balance sheet to accomplish their goals. So far. In addition to the intermediate-term consideration that this powerful tool remains available, the short-term consideration is that the ECB is not currently targeting the exchange rate.
If this works, European banks will increase lending to the real economy. Credit growth would lead to a pickup in investment. Economic growth will slowly accelerate. Sovereign yields would rise as a result of better growth expectations. Employment will rise. Some bad loans would be repaid, allowing banks to write down the truly hopeless ones. The asset quality reviews (a version of the US’ “stress tests”) could then be completed credibly, restoring trust in the European financial system. And then global capital would flow back into the Euro Zone.
Bottom Line: Global economic activity has been subpar since the start of the year, but growth will quicken in the second half as pent-up demand begins to propel the US economy and as the Euro Zone gains traction. The European Central Bank has announced a stimulus package that marks a new era for monetary policy in the Euro Zone, and profoundly changes the investment outlook for the region to the positive.