Can the US Continue to Lead Global Equities?

May 14, 2014 | By Rick Golod

Executive Summary
There are two trends in the US that are concerning to me: the reversal of US equities’ outperformance relative to global equities and the underperformance of the US financial sector relative to the broad US market. However, upside is still possible this year, and there are many reasons to stay invested in the US. This is also a good time to look at international markets, particularly Europe.

  • Neutral weight the US in the short term but overweight long term. First quarter gross domestic product (GDP) growth was more disappointing than expected, but the economy appears to be gathering steam in the second quarter. Against this backdrop, value stocks and cyclical sectors look compelling, in my view. Despite the recent weakness in financial stocks (the largest component in the S&P 500 Index), I believe this is not the year to “sell in May and go away.”
  • Neutral weight Europe. I believe European equities are likely to be supported by a decline in the equity risk premium. Investors who are waiting for fundamentals to signal an entry point may miss a potential rally.
  • Overweight Japan. Foreign investors have lost their patience with the Bank of Japan (BOJ), but Japanese stocks’ attractive valuations and earnings potential may be worth sticking around for.
  • Underweight emerging markets. Don’t get caught in the latest “go-go” growth stock rally. There are still many headwinds for the asset class.

Look abroad, but don’t leave home
A mix of soft economic data and concerns about a potential Ukraine-Russia conflict subdued global equity returns in April. Despite the soft performance, global equities did move higher for the month, but only by 0.7%. Europe was the best-performing region, up 3.6%, while Japan was again the worst performer, down 2.6%. The US and emerging markets rose 0.5% and 0.10%, respectively. Equity market performance is represented by the MSCI All Country World Index (ACWI), MSCI Europe Index, MSCI Japan Index, MSCI USA Index and MSCI Emerging Markets Index, respectively.

After lackluster returns for the past two months, US equities seem less attractive, especially when you consider that the S&P 500 Index hit an all-time high on May 12, and that both the NASDAQ and small-cap stocks broke important support levels. The S&P 500 Index financial sector, the largest sector in the index, has also underperformed the S&P 500 Index year-to-date. Finally, the S&P 500 Index’s relative outperformance over global equities, as measured by the MSCI ACWI, has stalled, and the S&P 500 Index risks underperforming going forward.

At the same time, the MSCI Europe Index’s underperformance relative to the MSCI ACWI appears to have bottomed. Given these conditions, I believe investors may want to focus on overseas opportunities until the US market confirms that this current uptrend will continue further.

US: Overweight long term, neutral short term
Though economic activity in the first quarter was widely expected to be slower than in previous quarters, the estimated 0.1% annualized GDP growth rate announced at the end of April was below many analysts’ projections. Undoubtedly, the harsh winter weather — which increased energy costs for consumers and businesses, reduced consumer spending and expanded inventories — was largely to blame.

As temperatures begin to rise, so should consumer spending, and ultimately GDP growth. What’s more, there are other factors that foreshadow a likely upside surprise in second quarter GDP growth. For example, a continuation of growth in nonfarm payroll employment and average weekly hours worked would bode well for consumers. Jobless claims also fell to a seven-year low in April, and have a 0.85 correlation to wages/salary growth, which could support increased consumer spending. Moreover, March retail sales (excluding gasoline) marked the strongest increase since 2010.

The manufacturing industry also looks poised to accelerate. For example, the Conference Board’s Leading Economic Index (LEI), which has historically been a strong leading indicator of industrial production, is at the highest level since December 2007. By one estimate, second quarter GDP growth could rise above 4%, given the recent rebound in purchasing manager indexes (PMIs) and jobless claims.

On the surface, a stronger economy should support a higher equity market. But the S&P 500 Index faces a major headwind as the financial sector, its largest sector, has been underperforming the market as a whole this year.

A popular Wall Street trading adage contends that summer is typically a seasonally weak period for US equity returns, and therefore equity investors would be better off sitting on the sidelines during these months. Could today’s headwinds be the impetus investors need to “sell in May and go away?”

I would say the answer is no for several reasons. First, a “sell in May and go away” until October investment strategy has succeeded only 36% of the time. Since 1948, market performance between May and October was positive 64% of the time, with an average return of 1.37%.

Second, in my opinion, LEI has been the most important metric in determining the direction of the equity market. Since 1948, when LEI rose from May to October, the S&P 500 Index was positive 79% of the time, with an average return just under 6%. When LEI was negative during those months, equity returns were negative 51% of the time, with an average decline of 2.19%. Currently, LEI has been up in 12 out of the past 14 months, and recent improvements in the Institute for Supply Management (ISM) manufacturing surveys suggest further gains are ahead.

Finally, recent strength in the energy sector could help offset weakness in the financial sector. Additionally, stronger GDP growth in the months ahead is likely to move interest rates higher, steepening the yield curve and improving the financial sector’s relative performance.

While some caution is warranted in the short term, I remain bullish on the US over the long term. I continue to believe that, in the current environment, value stocks in cyclical sectors of the market look attractive. In this commentary, the definition of value stocks is based on valuation metrics, such as price-earnings or P/E, price-to-book, free cash flow, or other profitability measures, and should not be confused with low beta, defensive or noncyclical stocks.

I believe cyclical outperformance is likely to return with better economic data. That’s because when the Citi Economic Surprise Index (ESI) is coming off a bottom, the hypercyclical sectors tend to outperform. Specifically, I believe the financials, technology (“old tech”) and consumer discretionary sectors are worth considering.

Gains in LEI and the Philly Fed Index — up 15.3 points in March and another 7.6 points in April — also point to potential value stock outperformance. Since 2005, when the Philly Fed Index is improving, the S&P 500 Pure Value Index has tended to outperform the S&P 500 Pure Growth Index. When LEI was accelerating, pure value generated almost 700 basis points in excess return (above the S&P 500 Index) over a 12-month period.

Small-cap stocks were down more than 3% year-to-date, as of April 30, as represented by the Russell 2000 Index. Overall, my outlook for small caps is cautious. However, small-cap stocks have tended to outperform large-cap stocks when the year-over-year percentage return in LEI was rising, as well as when financial conditions were accommodative. It’s important to note that Federal Reserve (Fed) Chair Janet Yellen recently said it would take two years for the US economy to meet the Fed’s goals, signaling the continuation of accommodative policy. On a technical basis, however, small-cap stocks have recently broken an important support level relative to large caps. Perhaps small caps’ valuations have become problematic for investors. Although this current downturn could be temporary, I would wait before adding to this asset class until an uptrend has reasserted itself.

Europe: Neutral weight
I continue to believe the European recovery is following the same path that occurred in the US. In my view, waiting to invest in European equities because of weak fundamentals is a risky proposition.

Investors who focused on US economic growth and equity fundamentals after the recovery probably missed most, if not all, of the US equity rally. Earnings did increase, however most of the return came from multiple expansion as a result of a decline in the equity risk premium (or ERP, which measures investor fear) and easing investor pessimism (sentiment). Investors focusing solely on European fundamentals could make the same mistake.

Granted, the European economic recovery is fragile. For example, deflationary pressures remain a risk to growth within the region. I also find it hard to believe that the European equity markets would remain immune to certain risks if the Ukraine-Russia conflict continues to escalate.

However, if the European economy continues to look less bad and interest rates remain low, in my opinion, the ERP is likely to decline, providing attractive upside for European equities. According to Goldman Sachs, the current risk premium priced into the European equity markets is 7.1%. The long-term average ERP since 1988 has been 3.7%. If the ERP were to decline to 4.2%, Goldman Sachs projects a potential 54% return.

As I see it, the risk in Europe centers on whether interest rates can remain low long enough for the recovery to take hold and for the ERP to decline. This may be difficult if interest rates rise in the US due to stronger economic growth.

Because the European Central Bank’s (ECB) monetary policy is likely to follow, or possibly mirror, the same path as the US’s, I believe the same investment themes that outperformed in the US are likely to outperform in Europe. For example, a lower ERP would likely lead to small-cap outperformance. Then, as the currency weakens versus the currencies of its trading partners, leadership is likely to shift to large-cap stocks.

I favor multi-cap managers that can adjust their small- and large-cap allocations when appropriate, as well as such strategies as Dogs of Europe (owning the highest-yielding stocks) and/or European Dividend Aristocrats (owning companies that consistently raise dividends), which could potentially mimic the returns seen in the US over the past five years.

Japan: Overweight
Until the BOJ increases quantitative easing again, the Nikkei 225 Index is likely to remain range-bound, despite attractive valuations and the best consensus earnings revisions ratio (with more upgrades than downgrades) of any region in the world. At 102.10 as of May 12, the yen/dollar exchange rate isn’t weak enough to motivate investors into Japanese stocks. In fact, a lack of patience with the BOJ has driven most foreign investors from the region. The Nikkei looks oversold and now under-owned. Sentiment also remains negative. Investors in this market should remain patient.

Emerging markets: Underweight
It’s difficult to get excited about the emerging markets asset class, despite what appears to be attractive valuations.

China’s manufacturing PMI contracted in April for the fourth consecutive month. Also, China’s MNI Business Sentiment indicator contracted for the second consecutive month. Money supply (M2) growth, at 12.1% year-over-year in March, was at its slowest pace since 2001. Yuan bank loans are at the lowest level since 2008. Even the real estate sector, which is so important to GDP growth and consumer confidence, is deflating, with real estate company profits declining and property transactions in seven major Chinese cities down more than 30%. In a nutshell, China is slowing, monetary conditions remain tight and more time is needed to digest the excess credit and investment growth that has taken place the past five years.

Despite the economic weakness in the largest emerging market country, emerging markets are going through their fourth “go-go” growth stock boom (1994, 1997, 2007 and today). Unfortunately, recessions tend to follow growth stock peaks. If 1994 is any guide, even without a recession, emerging market growth stocks’ price-to-book valuations tend to fall 50% and P/Es tend to decline 45%. Thus far, the price-to-book decline in these overvalued stocks have been less than 10%.

Investors who want to participate in this asset class should consider focusing on best-of-breed countries with healthy balance sheets, or on active managers who can focus on fewer stocks and are nimble enough to exit when necessary.

Final thoughts
Most developed markets are experiencing accelerating GDP growth with accommodative monetary conditions and low inflation. This combination is positive for equity returns, in my opinion.

Presently, the momentum in European stocks relative to global stocks, and the US financial sector’s relative underperformance, suggest Europe may be a better relative opportunity for now. A declining equity risk premium is likely to be a key driver of European stock returns over the next few years. Higher US interest rates and current European valuations could limit the decline in ERP in the short run until the recovery is on more solid footing.

Nevertheless, the US equity market remains an attractive region to overweight. The market’s rotation toward value could have staying power as value tends to outperform when the economy improves. The cyclical sectors found in the value indexes, both large and small, are likely to outperform. History suggests this is not the year to sell in May and go away, but to stay invested.

For Japan and the emerging markets, I think investors should wait for a better entry point.

Sources: Invesco; All data and information provided by Invesco as of May 14, 2014, unless otherwise noted. Additional sources include: Bank of America Merrill Lynch, MSCI, May 1, 2014; Bloomberg LP, Feb 28-May 13, 2014; Cornerstone Macro LP, March 24-May 6, 2014; Bank of America Merrill Lynch, March 27-May 5, 2014; Goldman Sachs, April 24, 2014; Gluskin Sheff, April 14-April 29.

The opinions referenced above are those of Rick Golod as of May 14, 2014, 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.

All investing involves risk including the risk of loss. Diversification does not eliminate this risk.
   The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
   In general, stock and other equity securities values fluctuate in response to activities specific to the company as well as general market, economic and political conditions.
   A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
   Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.
   Smaller company stocks offer the potential to grow quickly, but can be more volatile than larger company stocks, particularly over the short term.
   There can be no guarantee or assurance that companies will declare dividends in the future or that if declared, they will remain at current levels or increase over time.

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The S&P 500® Index is an unmanaged index considered representative of the US stock market. The MSCI All Country World Index (ACWI) is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of developed and emerging markets. The MSCI Europe Index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of the developed markets in Europe. The MSCI Japan Index measures the performance of Japan’s equity market. The MSCI USA Index measures the performance of the US equity market. The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization index designed to measure equity market performance of emerging markets. The NASDAQ Composite Index measures all NASDAQ domestic and international-based common stocks listed on the NASDAQ Stock Market. Correlation measures the degree to which two variables move in tandem with one another. Conference Board Leading Economic Index (LEI) is an economic indicator used to forecast changes in the business cycle based on a composite of 10 underlying components (including data on employment, manufacturing, consumer expectations, stock prices, money supply, interest rates, among others). PMI (formerly Purchasing Managers Index) is a commonly cited indicator of the manufacturing sector’s economic health calculated by the Institute of Supply Management. Price-earnings (P/E) ratio, also called multiple, is a common valuation metric for stocks that compares a stock’s share price to its per-share earnings. Price-to-book value is a common valuation metric for stocks which compares a stock’s share price to its book value per share. Beta is a measure of risk representing how a security is expected to respond to general market movements. Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. The Citi Economic Surprise Index measures how a variety of macro indicators “surprise” relative to expectations. The Federal Reserve Bank of Philadelphia Business Outlook Survey (also called the Philly Fed Index) is a regional survey of the health of the manufacturing sectors in eastern Pennsylvania, southern New Jersey and Delaware. The S&P 500 Pure Growth Index is a style-score-weighted index that measures the performance of S&P 500 stocks with pure growth characteristics and excludes those with both growth and value characteristics. The S&P 500 Pure Value Index a style-score-weighted index that measures the performance of S&P 500 stocks with pure value characteristics and excludes those with both growth and value characteristics. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. Equity risk premium is the excess return investors expect as compensation for assuming the risk of the equity market. The European Central Bank (ECB) is the central bank responsible for the monetary policy of the European Union. 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. Earnings revision ratio is a ratio of analysts’ earnings upgrades to earnings downgrades used to gauge analysts’ sentiment about the stock market. The MNI China Business Sentiment is a leading indicator of the current condition of China’s economy based on a monthly poll of Chinese business executives. Money supply is the total stock of currency and liquid instruments in a country’s economy at a given point in time. M1 is a standard classification measuring cash and checking deposits. M2 includes cash, checking deposits, savings deposits, money market mutual funds and certificate of deposits (CDs). Gross Domestic Product (GDP) is the monetary value of all finished goods and services produced within a country’s borders in a specific time period, usually calculated on an annual basis. Cyclical sectors are sensitive to the business cycle, such that revenues are generally higher in periods of economic prosperity and expansion, and lower in periods of economic downturn and contraction. A basis point is a unit that is equal to one one-hundredth of a percent. Dogs of Europe is the European version of the “Dogs of Dow” investing strategy that consists of buying the 10 DJIA stocks with the highest dividend yield at the beginning of the year. A Dividend Aristocrat is a company that has continuously increased the amount of dividends it pays to its shareholders. To be considered a dividend aristocrat, a company must typically have raised dividends for at least 25 years.