August 13, 2013
In July, investors continued to digest the ramifications of reduced quantitative easing (QE) in the US and mixed economic news from around the world. While certain factors can potentially extend the rally, I remain cautious about downside risks. Rather than trying to time the market, investors should examine the larger macro trends likely to drive the markets going forward and consider their implications for long-term equity portfolios.
- Overweight US. The bull market in the US could potentially be sustained by strong earnings from better revenue growth, high levels of cash on corporate balance sheets to support rising dividends and share buybacks, and higher market multiples as better employment figures and housing prices bolster consumer sentiment. That said, I believe the equity market could take a breather over the next couple of months while fundamentals catch up to current equity market gains.
- Overweight Japan. Prime Minister Shinzo Abe's commitment to continue aggressive QE may keep Japan's bull market intact as stocks advance on a weaker yen/dollar exchange rate.
- Underweight Europe. European economic growth could be in the early stages of emerging from recession. While economic data have improved for the past couple months, investors cannot rule out another flare-up from one of the peripheral countries, as balance sheets remain strained. Until the euro/dollar exchange rate improves, it will be difficult for these peripheral countries to grow their way out of their debt problems.
- Underweight emerging markets. Emerging markets seem to be at a crossroads — poised to either break out of their bear market or experience another down leg. Economic data continue to deteriorate, and technical indicators are inconsistent with previous market bottoms. I believe the region is likely to experience more downside.
Don't chase the rally
Global stocks had the largest monthly gain in more than a year, with the MSCI All Country World Index up 4.7% in July.1 Investors were encouraged that:
- China's manufacturing unexpectedly grew.
- Metal prices increased.
- US gross domestic product (GDP) was stronger than expected for the second quarter.
- Federal Reserve (Fed) Chairman Ben Bernanke reiterated QE would continue despite stronger growth.
For global equity markets to continue rallying over the next couple of months:
- The US equity market must overcome a couple of hurdles — namely, the debt ceiling and the beginning of QE tapering.
- Europe will need to continue to show better economic growth.
- The yen will need to continue to depreciate in Japan.
- Emerging markets will need to see a firming in commodity prices.
With mixed economic data in early August and many equity markets trading at multi-year highs, it's time for investors to reevaluate portfolio positioning strategies going forward.
The S&P 500 Index recently hit an all-time high at 1709.2 Interest rates are no longer in a bull market. Are US equities a buy, hold or sell?
July data provide some reasons for discouragement, including:
- Mortgage applications — down 11 of the past 12 weeks — are experiencing the fastest three-month collapse since June 2009. The 70 basis-point increase in interest rates has reduced mortgage refinancing 57% from its recent peak.3
- Payroll growth disappointed, real wage growth has been negative, and hours worked declined last month.4 Real disposable income is lower today than it was five years ago.5 Auto sales also fell short of expectations. 4
- After revisions, GDP growth for the first half of the year averaged 1.4%, which was also disappointing.6
- In July, analysts downgraded more corporate earnings estimates than they upgraded.7
Unless seasonal factors were responsible for the disappointing economic data, there doesn't appear to be much economic momentum heading into the third quarter. This is concerning because the influence of economic growth on stock market performance is likely to increase, with S&P 500 Index price-earnings (PE) multiples back to long-run averages and the tailwinds for corporate profit growth — a weak dollar, interest expense, depreciation and tax breaks — no longer in play.8
Despite plenty of reasons to take profits, I wouldn't be too quick to exit the equity market for these reasons:
- Second-quarter real GDP may have come in at 1.7%, but private sector growth is running at 2.2%. The difference was the fiscal drag. Next year, the consensus estimate for GDP growth is 2.7%, which should provide a boost to corporate top-line revenue growth, in my view.10
- Higher interest rates may indeed reduce real estate and auto sales activity, but I doubt it will derail the upward trend. I believe both these sectors should continue to contribute positively to GDP growth.
- The S&P 500 Index may have appreciated more than 150% from the low on March 9, 2009, to the high on Aug. 2, 2013, but corporate earnings have more than doubled.11 In one respect, the equity market is playing catch-up.
- Valuations, Wall Street equity allocations and bond yields relative to the S&P 500 Index are not at all-time highs, and investor sentiment is not euphoric.12 Current Wall Street equity allocations, as represented by the Bank of America/Merrill Lynch Sell Side Indicator, are at levels that have generated positive equity returns 95% of the time since 1985, with an average 12-month return of 27%.13
- Since 2008, the S&P 500 Index has been 94% correlated to the direction of unemployment claims, which recently hit a 5½-year low, suggesting higher equity prices.14
- For the past 10 years, the S&P 500 Index has been 95% correlated to the year-over-year percentage change in the Conference Board Modified Leading Economic Index, which rose in June and appears likely to rise in July, in my opinion, suggesting better year-over-year returns in the equity market over the next year.15
This doesn't mean the equity market can't or won't correct. Although I'm not a market timer, I am sensitive to the recent market run-up, the high margin debt levels, the low Chicago Board Options Exchange Volatility Index, or VIX, reading that suggests a certain degree of market complacency and other technical indicators that suggest the market is overbought.16 I wouldn't chase this market rally, but I also wouldn't become paralyzed and do nothing.
While investors who worried about "what ifs" over the past four years missed out on significant volatility, they also missed out on a 152% move in the market.17 Investors waiting for a pullback before adding capital to equities are still waiting. If you're worried about the market, consider moving away from managed portfolios with 200 to 300 stock positions and look for active managers running concentrated portfolios in the 50- to 80-stock position range.
Investors worried about the economy should consider underweighting the cyclical sectors/funds and overweighting the defensive (dividend-paying) stocks, sectors and funds. The level of concern about the economy should be reflected in an investor's portfolio dividend yield — typically the bigger the concern, the higher percentage of high-dividend-yielding equities.
Instead of trying to play the market pullbacks, think about positioning portfolios for what I believe could be the next major macro trends:
- Global economic expansion. The JP Morgan Global Purchasing Managers Index (PMI) suggests the global economy is healing.18 Over the past 10 years, growth stocks have trailed value stocks when the global economy entered a period of sustained expansion.19
- Higher interest rates. As the Fed tapers QE, interest rates are likely to move higher. Since 2003, value stocks have tended to outperform growth stocks when interest rates were rising (as represented by the S&P 500 Value Index and S&P 500 Growth Index, respectively).20 The 10-year correlation has been 0.90.
Rising interest rates have historically favored value stocks
- Stronger US dollar. The US dollar is likely to strengthen over the next couple years, in my opinion, as the current account deficit continues to decline, interest rates rise, and the GDP growth differential widens between the US and the rest of the world, providing global investors with the potential for a yield advantage and better fundamentals. I believe a strengthening dollar environment could benefit value stocks over their growth counterparts because relatively fewer multinationals are considered value stocks.
In summary, think about overweighting large caps over small caps, value over growth, domestic-positioned companies over multinationals and companies with high free cash flow over those with the highest dividend yield.
Europe: Neutral weight
Lately, it has become fashionable to be bullish on Europe. On the surface, Europe appears to be on the mend. Germany led the way to better economic data last month, as the PMI improved dramatically from 48.6 to 50.7.21 German factory orders also had the first year-over-year increase since October 2011.22 The eurozone PMI, at 50.1%, also improved and moved into expansion territory for the first time in almost two years.23 Leading indicators are consistent with 1% GDP growth going forward. 24
On closer inspection, however, economic momentum looks questionable. The German Ifo Business Climate Index showed less improvement in its July reading, and the expectations component ticked down slightly, remaining only a little above its long-term average.25 The earnings revision ratio continues to decline with more downgrades than upgrades, money supply and loan growth are falling, and the currency is appreciating.26
Furthermore, Italy, the third-largest country in the eurozone, remains troubled. It has averaged 0.4% GDP growth since 2000 — compared with 1.3% for the region — and is currently contracting at 2% for a host of different reasons.27
One of Italy's major problems is the relationship between the government and Banca Monte dei Paschi di Siena (BMPS), one of the country's largest and oldest banks — as well as one of its most insolvent and scandal-plagued. Italy has bailed out BMPS more than once and was asked in June to do so again. Why would the government do it yet again? Probably because the bank's bond holding hit an all-time high after it purchased more than €3 billion in Italian sovereign bonds in the second quarter alone.28 In other words, an insolvent bank is continuing to purchase the sovereign bonds sold by an insolvent government.
It will be difficult for Italy and other eurozone countries (besides Germany) to grow their way out of a low-growth environment with the euro strengthening to 1.33 versus the dollar (as of Aug. 8).29 Until the euro/dollar exchange rate moves lower (1.2877),30 I prefer to be selective rather than overweight the region.
I believe investors should continue to seek multinational companies within the region, based on their generally the high dividend yield, and wait for the potential earnings surprise, which will likely occur when the euro/dollar exchange rate declines. The wait may not be that long; the 2014 consensus euro/dollar exchange rate is 1.25.31
Japan: Neutral to overweight
Japanese QE is an experiment in progress. The Bank of Japan's goal is to reflate the economy. Weakening the yen provides Japanese companies with a pricing advantage that should help contribute to increased sales. Higher sales should lead to employment growth, driving economic growth higher. Increased demand should reverse deflationary pressures, at least in theory. Aggressive QE tends to weaken a country's currency, especially in a world where Europe's central bank is on hold and the US is likely to begin reducing its QE program.
But, the short yen/dollar trade is a crowded trade. Technical forces can sometimes reverse the longer-term trend of a weak currency. Invesco's chief currency trader Raymund Uy believes we could see a short-term reversal in the yen/dollar exchange rate that could take the yen/dollar to 94 or 95 before moving to 110 or higher.32 If this forecast is correct, the Nikkei 225 Index (97% correlated to the yen/dollar exchange rate over the past 12 months) would likely correct as it did in June.33 I would see such a correction as a buying opportunity with the belief that aggressive QE and uncompetitive bond yields will eventually drive the currency lower.
Emerging markets: Underweight
Despite a better-than-expected Chinese PMI and expectations of additional fiscal stimulus — which led to a rally in China's stock market — I don't think the bear market in emerging market equities is over yet.34 The asset class has not shown the normal investor capitulation (extreme selling) seen in previous market bottoms.
Additionally, some analysts have questioned the integrity of China's improved PMI reading — at 50.3 in July, up from 50.1 in June — given the country's liquidity squeeze and sharp declines in credit and monetary stimulus in the prior month.35 Although borrowing costs between banks have fallen from recent highs – which has helped ease credit conditions – other indicators point to potential credit shortages and escalating credit risk in the future.36 Tightening liquidity/credit conditions and slower growth do not bode well for Chinese stocks.
Export and import growth in emerging markets continues to slow, despite the recovery in the US economy and stabilization in eurozone economies. Because the US and Europe have contributed less to global growth over the past decade, their influence on emerging market growth has also diminished.
Emerging market domestic demand appears to be weakening as well, as retail sales in both Mexico and Brazil have languished considerably.37 Brazil may have 0% GDP growth this year as quickening inflation, rising interest rates — its central bank has tightened by 125 basis points this year so far — and uncertainty about government policies have reduced consumer confidence and spending.38
My major concern lies in the debt market and its potential to disrupt emerging market equities. Deteriorating economic data are weakening credit quality and currencies. Weak emerging market currency values increase inflation risk, which could lead to higher interest rates as central banks tighten. Emerging market debt yield spreads could widen amid diminishing credit quality, rising yields and a falling currency. This perfect storm could trigger margin calls in emerging market debt that could result in lower equity prices as investors sell quality stocks to fund debt positions.
I believe emerging markets are at a crossroads that could lead to another downturn in this asset class or a bottoming process that provides investors with a potentially attractive buying opportunity. But until I see capitulation or a catalyst — such as a bottom in commodity prices — I remain underweight this asset class.
The US equity market has overcome a number of obstacles this year and has had a great run. Technical indicators and current economic data suggest the equity market is trading ahead of fundamentals, in my opinion. As a result, the market could trade sideways to down over the next couple of months. Instead of trying to time the market, think about positioning portfolios for the next major move.
Over the next few years, I expect to see better US economic growth as the fiscal drag due to government spending cuts evaporates, higher interest rates as monetary policy normalizes and a stronger dollar as deficits decline. In such an environment, I expect value to outperform growth, large caps to outperform small caps because of foreign capital investing in the US, and cyclical sectors to outperform defensive sectors.
Europe appears to be improving, but I continue to prefer the US market. Japan is still a trade, but one worth considering given the likely decline in the currency over the next couple of years. Emerging market data still suggest an underweight position.
The opinions referenced above are those of Richard Golod as of August 13, 2013, and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of other Invesco investment professionals. The comments should not be construed as recommendations, but as an illustration of broader themes. Past performance is no guarantee of future results.
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The MSCI All Country World Index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of developed and emerging markets. The S&P 500® Index is an unmanaged index considered representative of the US stock market. Modified LEI measures the Conference Board Leading Economic Index (LEI) without money supply and the yield curve factored in. LEI is an economic indicator based on a composite of 10 underlying components (including data on employment, manufacturing, consumer expectations, stock prices, money supply, interest rates and others) used to forecast changes in the business cycle, calculated by The Conference Board. The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, shows the equity market’s expectation of 30-day volatility. The VIX is a widely used measure of equity market risk and is often referred to as the “investor fear gauge.” The JPMorgan Global PMI is a monthly measure of global business conditions based on surveys from the manufacturing and services sectors in more than 20 countries. The S&P 500 Growth Index is a capitalization-weighted index of all stocks in the S&P 500 Index that have higher price-to-book ratios. The S&P 500 Value Index is a capitalization-weighted index of all stocks in the S&P 500 Index that have lower price-to-book ratios. PMI (formerly Purchasing Managers Index) is a commonly cited indicator of the manufacturing sector’s economic health calculated by the Institute of Supply Management. The Markit Eurozone Manufacturing PMI gauges the health of the manufacturing sector in the eurozone based on surveys of manufacturing firms. The Ifo Business Climate Index is a commonly cited early indicator of economic development in Germany. The Nikkei 225 Index (or Nikkei Index) is a price-weighted index measuring the top 225 blue chip companies on the Tokyo Stock Exchange and is commonly considered representative of Japan’s stock market. The Shanghai Stock Exchange Composite Index measures the performance of all stocks (A and B shares) traded on the Shanghai Stock Exchange. A basis point is a unit that is equal to one hundredth of a percent. Price-earnings multiple is a simple numeral usually used to express a price-earnings ratio. Price-earnings ratio is a common valuation metric for stocks that compares a stock’s share price to its per-
share earnings. Correlation measures the degree to which two variables move in tandem with one another.