Mid-Year Review: Six Investor Concerns That Aren’t Worth Losing Sleep Over
July 17, 2014 | By Rick Golod
In the first half of the year, global equities moved higher despite the fact that economic growth fell short of expectations, particularly in the developed world. I believe this trend has been confusing for investors, who may be wondering whether the various recoveries have suffered from temporary setbacks or are simply resetting their courses at a slower pace.
In this month's commentary, I examine some of the most common concerns I've been hearing lately and explain why such pessimism is often unjustified. As we head into the latter half of the year, I remain bullish on global equities, and my regional tilts are unchanged from the last several months.
- Overweight US. Economic growth looks on track to strengthen in the second half of the year, which could compel the US Federal Reserve (Fed) to increase interest rates sooner than expected. However, at this point, I still believe a severe correction in the market is unlikely, as low volatility is to be expected at this point in the business cycle and valuations are not yet at problematic levels.
- Neutral weight Europe. Although economic data have weakened recently, the European Central Bank (ECB) appears committed to bolstering the recovery. European equities may continue to benefit from a declining equity risk premium.
- Overweight Japan. Japan could surprise us in the second half of the year, as Prime Minister Shinzo Abe's "third arrow" structural reforms are enacted.
- Underweight emerging markets. Liquidity could drive emerging market equities higher in the short run, but beware of the downside risk that has historically followed rallies. Opportunities may be available on an individual country basis.
Can't sleep? Try counting bulls
This year was expected to be a year of higher economic growth, higher interest rates and a stronger dollar in the US — all conditions that typically would lead to lower commodity prices and emerging markets' underperformance. Instead, investors saw lower growth, lower interest rates, a slightly weaker dollar and higher commodity and emerging market equity prices.
Still, that didn't keep equity prices from moving higher. The second quarter ended on a high note for global equities. The MSCI All Country World Index traded at an all-time high in June, up 1.7%. Japan, up 5.2%, led global equities. Europe, down 0.30%, was the only negative performer on a regional basis. (Japan, Europe and emerging markets are represented by the MSCI Japan Index, MSCI Europe Index and MSCI Emerging Markets Index, respectively.)
The S&P 500 Index's 7.14% gain in the first half of the year bested the performance in other regions. Emerging markets were up 4.8%, Europe rose 3.4%, and Japan posted the only negative return, down 0.30%, year-to-date.
In the US, value stocks edged out growth stocks, large caps outperformed small caps, and the defensive sectors (utilities) beat cyclicals (financials) in the first half of the year. It's important to note a rotation in leadership occurred during the six-month period.
Disappointing economic growth and/or lower interest rates gave the edge to large caps, growth stocks and noncyclical sectors earlier in the year. But reassurance from Fed Chair Janet Yellen that rates would stay on hold for an extended time period triggered a "risk-on" rally that boosted cyclical sectors and small caps near the end of the second quarter.
Despite positive equity returns, I've noticed in my recent travels that investors seem somewhat negative about this synchronized bull market. I've been hearing many of the same underlying causes for investors' sleepless nights. But I believe it's time to put some of these concerns to bed.
Concern #1: Disappointing economic growth in the first quarter presages future weakness
The first quarter's -2.9% gross domestic product (GDP) quarterly annualized growth rate appears to have been an outlier, as six one-off events acted as headwinds to economic growth. Such headwinds included the Affordable Care Act (ACA) rollout, the "polar vortex," the end of extended jobless benefits, the expiration of emergency bonus depreciation, an auto inventory unwind and tighter mortgage underwriting rules. Since then, each of these events has either improved or become irrelevant, in my opinion.
The current consensus GDP growth estimate for the second quarter is 3.3%, which I believe is supported by a number of metrics. The Chicago Fed National Activity Index, the most comprehensive measure of the state of the economy, ended May up 0.21% — the third positive reading in the past four months. (Index levels above zero indicate above-trend growth.) The year-over-year percentage change in the Conference Board's Leading Economic Index (LEI), which was up 5.9%, suggests above-trend economic growth over the next six months. Over the past 20 years, the year-over-year percentage change in GDP has been 82% correlated to the year-over-year percentage change in LEI.
Furthermore, data on manufacturing, corporate spending projections, banking sector health and bank lending have all seen improvements in the past several months. Consumers' ability to spend also looks likely to continue improving.
Concern #2: Valuations are stretched
As of July 10, the S&P 500 Index was trading at 17.98x trailing earnings and 15.7x 12-month forward earnings. Yet, based on the current direction of inflation and the dollar, the forward price-earnings (P/E) ratio is still below the long-term average of 16.4x.
With that said, P/E levels and one-year market returns have zero correlation. The question is whether investors will pay a higher multiple for earnings going forward, which depends in part on consumer confidence and investor sentiment.
The dollar has had a 76% correlation with P/Es over the past five years. Stronger economic growth should move interest rates higher and strengthen the dollar. Additionally, P/E multiples tend to expand when economic growth outpaces inflation.
However, valuations can become problematic at a certain level. As shown in the chart, the S&P 500 Index has tended to struggle when the forward P/E breaks above 17x. But this has happened only three times in the past 15 years.
Concern #3: There hasn't been a 10% correction in more than 32 months, and the low level of stock volatility suggests investors are too complacent
The market has gone 32 months without a 10% correction only four times in history. On one of those occasions, in the 1990s, the market didn't have a 10% correction for eight years.
Funny thing, I don't remember bull markets dying of old age!
When the economy is firing on all cylinders, a weak data point here or there doesn't create much of a panic for investors. This is reflected in the VIX volatility index, a gauge of volatility in equity prices. The VIX index has been trading about 50% below its average since 2000. While some see low volatility as a sign of investor complacency, I believe it's normal, given this point in the business cycle. The VIX index has been 71% correlated to the ISM Manufacturing Index in the past.
Furthermore, the VIX index historically hasn't been a useful predictor of equity returns. Changes in the VIX index have almost no correlation with equity market returns over any time horizon.
Finally, I think investors may be more confused than complacent. The American Association of Individual Investors' (AAII) measure of neutral sentiment, which gauges the number of investors who have views that are neither bullish nor bearish, is near 10-year highs.
Sleep on this: I believe stronger economic growth in the second half of the year is likely to increase interest rates and strengthen the dollar, which may amplify market volatility, lift stock prices and encourage a rotation from fixed income to equities.
In the above scenario, I believe small-cap stocks could outperform large caps, but not until the Russell 2000 Index breaks above its March level of 1213.55. Until then, large-cap value is likely to outperform both small caps and growth stocks, with the cyclical sectors (financials, technology, selected consumer discretionary) outperforming the noncyclical sectors.
The S&P 500 Index has continued to trade above its five-month moving average (1900), which I believe confirms that the uptrend remains intact. Therefore, any market weakness could provide a buying opportunity, in my opinion.
Europe: Neutral weight
Concern #4: European economies are weakening
Although the eurozone's manufacturing Purchasing Managers Index (PMI) fell in June, it remains elevated, at 51.8, indicating economic expansion. German manufacturing and business confidence readings also fell in recent months. As I've stated before, I believe Europe's mild weather in the first quarter frontloaded economic activity early in the year — at the expense of the second quarter.
ECB President Mario Draghi's recent actions and comments suggest that additional monetary stimulus is awaiting if needed, as I believe he realizes that economic growth is too low and the currency is too strong. As I expect the euro/dollar exchange rate to weaken in the second half, I favor large-cap multinationals with high or rising dividends.
Sleep on this: Europe's economy is likely to grow in fits and starts, but overall, is likely to slowly improve. Mr. Draghi's monetary policies will likely lead to a lower equity risk premium, driving equity prices higher. Negative interest rates may also help price multiples expand.
Concern #5: Two of Prime Minister Abe's 'three arrows' — massive monetary stimulus and fiscal stimulus — may be running their course
I believe the third arrow, which would increase the equity allocation in the country's pension fund, could be an important catalyst that moves Japanese, and even US, equity prices higher.
According to research from the Royal Bank of Canada, a 1% change in equity allocation could drive $5.8 billion into US equities, which is equivalent to four to 10 months of US equity mutual fund flows. Capital flows into the Japanese equity market could be a major catalyst that potentially takes the Nikkei 225 Index to higher levels.
Sleep on this: Japanese stocks could surprise us in the second half of the year because expectations have been so low. Even with the consumption tax administered in April, the economy has shown signs of improvement. The unemployment rate declined to 3.5%, the lowest level since 1997, which bodes well for earnings, as earnings have had a 68% correlation with unemployment in the past.
Emerging markets: Underweight
Concern #6: Am I missing the next bull market in emerging markets?
As of July 11, emerging market equities have rallied 15.9% since the Feb. 5 low, driven by low valuations, better economic data and liquidity from the Fed and the ECB.
As shown in the chart, emerging market equities have experienced a tradable rally every year since 2010 — with relative outperformance versus the S&P 500 Index — only to fizzle and move to lower levels. Let's also not forget the decline in emerging market equities in 2013 after the Fed taper rumors began.
I believe the current rally could fizzle, too. Investors should expect downward pressure on emerging market equities when interest rates or the dollar, or both, appreciate.
Sleep on this: Emerging markets could continue to trade higher for liquidity reasons, and not on improving fundamentals. Investors should continue to focus on individual country or stock-specific opportunities. With that, in recent months I liked India over China, and highlighted Russia back in March and April. India's stock market was up almost 24%, and China's was down almost 6% year-to-date through June 30, while Russia's stock market was up 33% from March to June 30.
Sources: Invesco; All data and information provided by Invesco as of July 17, 2014, unless otherwise noted. Additional sources include: Bank of America/Merrill Lynch, July 1-July 9, 2014; Bloomberg LP, May 31-July 11, 2014; Gluskin Sheff, June 11, 2013-June 24, 2014; Cornerstone Macro LP, Aug. 27, 2013-June 30, 2014; Thomson Reuters Datastream, May 15-July 9, 2014; Yardeni Research, Inc., June 9, 2014; Renaissance Macro Research, July 1, 2014; Citigroup Global Research, June 30, 2014; RBC Capital Markets, June 26, 2014.
The opinions referenced above are those of Rick Golod as of July 17, 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. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions, there can be no assurance that actual results will not differ materially from expectations. Past performance is no guarantee of future results.
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 values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
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.
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.
Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound.
Smaller companies offer the potential to grow quickly, but can be more volatile than larger-company stocks, particularly over the short term.
Underlying investments may appreciate or decrease significantly in value over short periods of time and cause share values to experience significant volatility over short periods of time.
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The S&P 500® Index is an unmanaged index considered representative of the US stock market. The European Central Bank (ECB) is the central bank responsible for the monetary policy of the European Union. 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 MSCI Japan Index measures the performance of Japan's equity market. 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 Emerging Markets Index is a free-float-adjusted market-capitalization index designed to measure equity market performance of emerging markets. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. 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 consensus estimate reflects forecasters' average or mean predicted figure for data such as gross domestic product or a company's earnings. The Chicago Fed National Activity Index is a monthly measure of overall economic activity and related inflationary pressure. The 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). Correlation measures the degree to which two variables move in tandem with one another. 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. Trailing price-earnings (P/E) ratio is a measure of a stock's value calculated by dividing its current share price by its earnings per share over the previous 12 months. Forward price-earnings (P/E) ratio is one measure of the price-earnings ratio that uses forecasted earnings (usually for the next 12 months or the next full fiscal year), rather than current earnings, for the calculation. The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, shows the equity market's expectation of 30-day volatility, used to measure equity market risk and commonly called the "investor fear gauge." The American Association of Individual Investors (AAII) Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish and neutral on the stock market for the next six months. The Markit Eurozone PMI Composite Output Index gauges the health of the manufacturing and services sectors in the eurozone. 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. The S&P BSE SENSEX is an index measuring the performance of the 30 largest, most liquid stocks across key sectors in the Indian stock market. The MICEX Index is a market-capitalization-weighted index measuring the performance of the 50 most liquid stocks on the Moscow Exchange and is considered representative of Russia's stock market.