Market Roundup - October 2012
October: A trick or a treat?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
September was a busy month for central bankers. The Federal Open Market Committee (FOMC) and the European Central Bank (ECB) both pledged to provide additional liquidity to the markets, which partially—if not wholly—explains why the S&P 500 Index reached a 52-week high of 1,474.51 and registered its third straight quarter of gains. When the economic data gave mixed messages, markets retreated from their highs. With the ECB and the Bank of Japan meeting during the first week of October, global production numbers being reported, the FOMC meeting toward the end of the month, and the U.S. presidential candidates debating throughout the month, October could deliver either a trick or a treat for investors.
The economyBy Brian Jacobsen
Central banks seem ready, willing, and able to snap to attention when the markets demand it. While that could provide a nice backstop for asset prices, it’s no assurance markets will have a smooth ride. Relying on central bankers to bail out investors might be a losing strategy in the short term considering a variety of forces are at work to increase market volatility. After all, it is an election year.
Election years do not necessarily bring additional volatility to the markets. In fact, there’s almost no statistical evidence to suggest that stock prices or interest rates behave more erratically in an election year. Although it’s dangerous to say this, we think this year could be different.
For the past few years, geopolitics dominated the headlines and added to, if not multiplied, market volatility. With heightened tensions between Israel and Iran; escalating conflict in Syria; territory disputes between China and Japan; worker strikes in South Africa; currency concerns in Argentina; risks of famine in North Korea; protests in Spain, Portugal, and Greece; and the upcoming U.S. presidential election, markets could be particularly touchy. In such an environment, we anticipate divergence: In each asset class, there will probably be some big winners and big losers. We believe what you’re not invested in might be more important than what you are invested in.
Anticipating the electionMost elections don’t have an immediate market impact mainly because markets are forward-looking: They anticipate outcomes. They don’t always get it right, but they do often enough. Although various industries and companies could do better or worse depending on the political balance in Washington, D.C., it’s likely that stock prices will reflect that well before election night. If it’s a close election outcome, then there could be a lot of room for stock prices to react to the election results. The debates between the candidates could be interesting for investors.
There seems to be some fairly decent conventional wisdom about which industries should benefit under a Republican or Democratic president. Under Republican control, large commercial banks, managed care (private insurers), biotechnology, and health care equipment firms could have a slight advantage if the Dodd-Frank Act (financial regulation) and the Affordable Care Act are rolled back or modified. Energy could also be an ideal sector if regulations favor coal, oil, and natural gas production. Information technology (IT) could also do well with the prospect of tax relief for repatriated profits given the sector’s large portion of profits earned outside the U.S. Finally, considering the traditional Republican support of the defense budget, defense-oriented firms could also benefit.
Under a Democratic president, alternative energy and materials would likely relatively outperform. Alternative energy would fit the president’s agenda for reducing reliance on conventional energy sources. Materials could get a bump if there is a push toward infrastructure investment: Roads, bridges, and buildings require a great deal of materials. Pharmaceutical, health care service, health care facility, and hospital firms could relatively outperform if provisions of the Affordable Care Act are upheld and implemented.
However, some of this conventional wisdom could be turned on its head. Various Republicans seem intent on cutting government spending even if it means cutting the defense budget, and some Democrats seem willing to entertain changes to Social Security, Medicare, and Medicaid to get budget deficits under control. As a result, the election may not give as much certainty to the markets about the path of government policies as conventional wisdom would suggest.
We think it’s safe to say that the next legislative session is likely going to be focused almost entirely on the government’s budget. Without one party getting at least 60 seats in the Senate, then only budgetary matters can be passed.
If Congress continues to be divided after the election, it is most likely that current policies will simply be extended year after year until the 2014 mid-term elections. The tax increases called for under Health Care Reform would likely go into effect (that is, the health insurance tax on high income earners’ investment and wage income), though income tax rates seem unlikely to revert to their pre-2001 levels. Republicans will not countenance an increase in the top two tax rates, and Republican support will be necessary to have any chance of surviving a vote in the House of Representatives. Similarly, spending is not likely to be cut significantly under a divided Congress, because Republicans may be able to avoid defense spending cuts in exchange for the tax increases under Health Care Reform. It is also likely that in exchange for not cutting spending, the payroll tax cut of two percentage points and the extended and emergency unemployment benefits will go away. That doesn’t favor consumer discretionary companies that cater to a lower-income clientele.
EquitiesBy John Manley
September is supposed to be a difficult month for stocks, but the traditional patterns broke down this year. Buoyed by the anticipation of encouraging statements from central banks on both sides of the Atlantic (to be followed by indications of more emphatic monetary stimulus in China), stocks soared in the first half of the month and then drifted slightly lower in the second half. It was a textbook example of the anticipatory nature of equity trading.
At the end of the month, the net numbers were still quite strong. The S&P 500 Index gained 2.4% in September (5.8% in the third quarter), while the Dow Jones Industrial Average tacked on 2.6% (4.3% in the quarter). The Nasdaq Composite lagged with only a 1.6% increase. Small stocks performed somewhat better, as evidenced by the Value Line Composite’s gains of 2.9% in its arithmetic index and 2.5% in its geometric index. The Russell 3000® Value Index (up 3.0%) outperformed the Russell 3000® Growth Index (up 1.9%).
The price gains were widespread, with all of the equity sectors producing increases in the month. Despite the superficial appearance of a risk-on environment, the two best-performing sectors for September were actually somewhat defensive in nature. The leader was telecommunication services, which advanced 4.0%. The area’s high current yield continues to attract money and may do so for some time. However, its rather extended valuation on other metrics limits us to a market weighting. Health care, up 3.97%, the second-best performer, is of more interest to us. We continue to overweight the area despite its move from a discounted price/earnings ratio (P/E ratio) to a premium P/E ratio over the past year. This month’s outperformance occurred as President Obama edged higher in the polls, which suggests to us that this is not a play on the repeal of the Affordable Health Care Act. Rather, we see it as a growing recognition of the demographic realities that may push money in the direction of health care in the years ahead. In addition, we are also impressed by the flexibility that the sector’s larger companies should have in the reinvestment or disbursement of their cash flows.
The best-performing sector in the third quarter was energy with a 10.1% price appreciation. For the month of September, the energy sector rose by 3.36%. Valuations in the sector have risen from very depressed levels but, in our opinion, remain quite attractively priced. Another of our favored sectors, IT, lagged in September (up only 1.2%) due to European economic weakness weighing on earnings expectations. However, the sector outperformed in the quarter (+7.45%). We continue to believe that the current corporate technology cycle is not at an end and that still-modest multiples have room to expand.
The utilities sector was the worst-performing sector for both the month and quarter. It gained only 1.2% in September and declined 0.5% in the past three months. Consequently, we remain neutral on utilities. The second worst-performing sector, in both the quarter and the month (3.8% and 1.5%, respectively), was consumer staples. We recently reduced our recommended overweighting to a market weight to reflect the area’s extended valuations as well as our belief that emerging and developed equity markets have reached a point where investors should again consider investing directly there and not indirectly through consumer staples.
Price performance definitely improved for emerging markets last month. In U.S. dollar terms, China, India, Brazil, Mexico, and Russia outperformed the S&P 500 Index in September after lagging over the past year—a significant shift, in our belief. Despite our view that the area will offer superior equity returns over the long run, we have stayed on the sidelines in emerging markets over the past 12 months. While there is no perfect time to re-enter this arena, we believe that we are close. We will take a hard look at emerging countries’ manufacturing and export space while remaining wary of the financials sector in both emerging and developed markets.
Developed markets overseas also tended to outperform the U.S. last month, but the shift was not as dramatic and the outperformance, generally, was not as marked. We believe that Europe is moving forward on resolving its problems. Although many vexing issues still remain, we think that we are near an entry point for European equities. While they may not have the secular growth potential of the emerging markets, we believe that the potential for an extended cyclical rebound at some point in the future is quite real.
BondsBy James Kochan
Treasuries struggled again in September and in the third quarter, while the credit sectors continued to perform exceptionally well. As a result, the year-to-date performance advantage from owning corporates and municipals widened further.
Table 1: Year-to-date bond market total returns (%)
The Treasury market posted negative returns for the second consecutive month. Investors were disappointed that the Federal Reserve (Fed) will be buying mortgage-backed securities (MBS) instead of more Treasuries in the months ahead. The market recovered somewhat late in the month when bad news from Greece and Spain rekindled the safety bid. Historically, this market has advanced when demand from overseas has been strong and has retreated when that bid has weakened.
The rally in mortgages following the Fed’s announcement mid-month allowed the MBS sector to outperform Treasuries by an unusually wide margin. Thus far in 2012, the agency MBS market has outperformed by a much smaller margin, which is closer to what past experience would have predicted. In contrast, the commercial mortgage-backed securities (CMBS) market, with a year-to-date return of 7.6%, has performed almost as well as most investment-grade corporate sectors.
The weaker segments of both the investment-grade and high-yield corporate market have produced strong returns thus far this year. The BBB-rated credits have recorded year-to-date returns 330 basis points (bps; 100 bps equals 1.00%) greater than the AA-rated credits. One sector of the investment-grade market has outperformed the high-yield market. Bank debt has produced a year-to-date return of 12.7% and a third-quarter return of 5.2%.
In high-yield bonds, the CCC-rated and weaker index has a year-to-date return of 15.7%, versus a return of 11.3% for the BB index. In the third quarter, that differential was not as large. The CCC index return was 5.2%, while the BB return was 4.5%. The quest for yield has clearly been the major theme in the taxable markets in 2012. The pattern of returns thus far in 2012 is the reverse of 2011 when Treasuries outperformed investment-grade and high-yield corporates.
The municipal market also struggled somewhat in late September, as a seasonal build-up in new-issue calendars led to a more cautious market tone. Yields rose slightly in most maturities and credit sectors. In a departure from earlier months, the A and BBB credits did not outperform in September. For the third quarter and for the year-to-date period, however, the A/BBB credits have outperformed the AAA/AA sectors by 50 and 320 bps, respectively. Because the municipal market yield curves remain steep, the longer maturities continue to outperform. Maturities of 10 years and longer have outperformed the seven- to 12-year maturities by 400 bps thus far in 2012.
Asset allocationBy Brian Jacobsen
Investment horizonsFor investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income. Short-term, over the next two months, unusually high market volatility should bias a portfolio toward higher-yielding safe-haven assets that can be deployed quickly when the market drops.
EquitiesWithin the equity portion of a portfolio, long-term, we prefer a barbell strategy focused on U.S. assets and select emerging markets assets. This results in a portfolio relatively unbiased in terms of the equity allocation between developed and emerging markets but a portfolio heavily biased toward U.S. assets and away from non-U.S. developed assets. We are looking for opportunities in Europe. As the U.S. markets reach the upper half of our projected trading range for the rest of the year (1,400 to 1,550 on the S&P 500 Index), we like trimming the U.S. and adding to multinational, export-oriented European equities.
Value versus growthBased on the relatively equal valuations given to growth and value stocks and our belief that the U.S. economy is not going to dip into a recession within the next six months, we prefer growth over value. Further, value indexes tend to be dominated by financials. While we think financials will survive, they might not thrive in the current regulatory environment. That could change if there is a Republican takeover of the Senate. Prospects of regulatory forbearance for financials could be a boon to bank stocks. As a result, we recommend a heavy overweight toward growth and a corresponding underweight to value, although we do like the value space, provided you don’t try to hug a benchmark in that area.
Large caps versus small capsWhen dividing the equity universe between large-cap and small-cap stocks, we think large-cap companies are better positioned to maintain profit margins and revenue growth. Input prices are extremely volatile, and credit markets are still not back to normal—although they are returning to normal in the U.S. Small-cap stocks also appear to be trading at slightly higher valuations compared with large-cap stocks. While we prefer large-cap stocks, we do not recommend a heavy overweight because there are many selective opportunities in the small-cap space. The large companies with huge amounts of cash on hand will likely look to expand market share or penetrate new markets through strategic acquisitions. As evidenced by some recent acquisitions, executives at large-cap companies may be willing to pay premium prices for acquisitions. For this reason, it will be important to be selective and invest in companies making prudent acquisitions.
Fixed incomeBased on our economic outlook, we believe that interest rates are likely to remain low for the next two years. This presents an opportunity for investors to take on additional duration and credit risk. Provided the economy does not dip into a recession, default rates should not increase, meaning the increased yields on higher-yielding debt may provide better income to investors than the lower-credit-risk issues would.
Asset allocation summary table1The blue bar on each diagram below represents our recommended tactical positioning for investors looking to make adjustments to their portfolios based on current market conditions. The green bar represents our recommended strategic positioning for investors with a time horizon of three years or more.
The bottom lineTax and spending reform almost necessarily needs to happen in the U.S. but may not occur until after the 2014 mid-term election at the earliest. A divided government can be useful but only if you are already on the right track. Even if we are left with a divided government after the upcoming election, we think investors can still look forward to longer-term reforms and invest for growth. It just might take longer for those investments to pay off.
The year 2014 could be a 1986 moment where we achieve real tax reform. In 1986, politicians were backed into a corner by the voters to get the job done. They did. The year 2010 was a tidal shift in the House, but tides move slowly. It might take until 2014 before the behemoth of a ship of tax and spending reform actually turns toward pro-growth policies.