Market Roundup - October 2013
October: BoogeymenBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
Over the past few years, it has seemed as though the economy was teetering on a cliff or was embroiled in some crisis. The eurozone was about to fall apart. The U.S. government was going to default on its debt. China’s economy was going to have a hard landing. The U.S. government was going to slash and burn spending while sticking it to taxpayers. The Federal Reserve (Fed) was going to taper.
As the U.S. government approaches the debt ceiling in October (or November), we think it’s time somebody pointed out the truth: A lot of these crises are boogeymen. They are scary, but not likely to do lasting damage. Maybe it’s time to wake up and stop believing the horror stories. Yes, bad things would happen if the eurozone collapsed or the U.S. government defaulted on its debt. But we believe that neither of these is probable, and so they’re not worth worrying about.
The economyBy Brian Jacobsen
The Fed decided to not taper its asset purchases in September. The looming budget battle and debt ceiling debates were no doubt weighing on the committee members’ minds. There has been significant improvement in the labor market, as measured by the change in the unemployment rate since the latest round of asset purchases began in September 2012, but the improvements haven’t been substantial, to use the Fed’s term. Substantial, apparently, means a combination of significant and sustainable. With ongoing fiscal drag and the prospect of more, Fed members erred on the side of caution by not tapering.
Fixed-income yields declined after the Fed announcement, and equity markets rallied. The equity market rally was short-lived, as issues about the sustainability of corporate profits lingered and new issues were raised about the stability of the Italian government. The U.S. government shutdown probably also weighed on equities, but historically, government shutdowns haven’t broadly dragged down corporate earnings.
These market movements should lay to rest any doubt about whether the Fed matters to the markets. The surprise (though not a surprise to us) announcement that the Fed would not taper in September pushed fixed-income markets significantly higher. The effect on the equity markets was much more mixed. Now that the U.S. government is embroiled in a budget and debt ceiling fight, the Fed is not likely to rock the boat. That means monetary policy will likely stay accommodative for at least a few more months.
The debt ceiling debate that will likely come out of D.C. will fill a lot of television time and print space. It deserves neither the time nor the space, in our opinion. Most people point to the August 2011 debt ceiling debate and the August 5, 2011, downgrade by Standard and Poor’s of the U.S. government debt as the cause of the market declines around that time. That would be a misreading of history, confusing correlation with causation. In fact, the market declines started at the end of July, when it was reported that the U.S. economy was smaller, the recession was worse, and the recovery was weaker than everyone previously thought. Add to the economic downgrade the problems in the eurozone and the lack of assurances from policymakers there, and you already had the makings of a dropping market. Although the debt ceiling debate and government debt downgrade didn’t help matters, it would be wrong to give them causal powers. We don’t assume that future debt ceiling debates will be like the one in August 2011.
EquitiesBy John Manley
Despite a series of cliff-hangers and one cliff, the equity market managed to shrug off the September curse and post a solid gain for the month. Perhaps a troubled August set the stage for the rebound that we saw. September started with lingering worries about Syria, the prospect of a tapering of the Fed’s quantitative easing, and a reprieve from the Fed. It ended with gridlock in Washington and a partial federal government shutdown. That was a lot of news for one market to digest in 30 days.
But digest it, it did, and when the bell rang to end the quarter, the S&P 500 Index had returned a healthy 3.1% in the period. The Dow Jones Industrial Average returned a respectable 2.3%, and the Nasdaq Composite Index rose a healthy 5.1%. The gains appeared to be fairly broad-based as well. The Value Line Arithmetic Composite Index gained 5.5%, and the Value Line Geometric Composite Index gained 5.3%. Growth outperformed value. The Russell 3000® Growth Index added 4.7%, while the Russell 3000® Value Index gained a perfectly acceptable 2.8%.
No one would say that September was pretty, but, in the end, it was pretty profitable for equity investors. The disparity is a function of the skepticism that we believe continues to lurk just beneath the surface of the majority of investors. In our opinion, few are comfortable—and most are queasy—about a series of short-term issues that lie before us. As a result, September left us as it found us: with modest valuation, an accommodative Fed, and fundamentals that appear to be grinding toward improvement.
The sector work showed a clear shift toward more cyclical areas, in our opinion. The best showing was the industrials sector, which climbed 5.7% over the period. Second place went to the cyclically sensitive consumer discretionary sector, with a 5.4% gain. Even the deeper cyclicals did well. The materials sector finished third, with a 4.4% gain in September.
The laggards were a litany of early-cycle noncyclicals. The only sector to post a decline in the period was the high-yield, bond-like, telecommunication services sector, which dipped 0.5%. The utilities sector did only slightly better, with a 1.1% gain, while the large multinational consumer staples sector managed to advance only 1.3%.
Two areas were of special note. Unlike other noncyclicals, the health care sector outperformed the market with a 3.2% gain, in anticipation of greater government spending on medical care and devices in the months ahead. For the time being, we are maintaining our overweight recommendation in this area. Another sector we favor, information technology, gained only 2.9% in September, slightly less than the market. We continue to believe that this area offers value as well as exposure to the corporate technology upgrade cycle, both here and in Europe.
Overseas, the market tone seemed notably better than it had been only a few months ago, as the delay of tapering pushed the dollar lower. The developed markets generally kept pace with or outperformed our own. The FTSE 100 Index gained only 0.9% in local terms, but the appreciation of the British sterling transformed that into a 5.6% gain for dollar investors. Germany, France, and Italy were up 6.1%, 5.5%, and 5.0%, respectively. The strong euro added another 250-plus basis points (100 basis points equals 1.00%) to U.S. investors’ returns. The recent problem areas, Spain and Greece, soared in September, with gains of 11.0% and 12.7%, respectively, in local terms. It appears to us that the European markets are sensing a meaningful improvement in the European outlook.
Emerging markets also advanced, but their rebounding currencies added to their dollar returns. India gained 4.1%, but a rise in the rupee moved that to a 9.8% gain for U.S. investors. Brazil gained a healthy 4.7% in local terms, but the currency rise translated that into an 11.8% gain in dollar terms. Russia and China saw no currency effect in their return numbers, but Russia gained 10.2% in local terms and China rose 3.6%. Japan did well, with an 8.0% gain with or without currency adjustments.
In sum, offshore did better than domestic investments for U.S. investors last month. We had more distractions at home, and that may remain true for some time. However, we continue to believe that the world’s economy is slowly turning toward the better and that the positive impact of that has yet to be fully discounted in the world’s equity markets.
Fixed incomeBy James Kochan
Because it was hurt most by the April-to-August market correction, the municipal market staged a strong recovery in September. For the third quarter, however, it was the poorest performer, largely because of steeply negative returns from the BBB sector. While the AAA sector had a quarterly return of 0.44%, the BBB sector return was -4.9%. Approximately two-thirds of that BBB return can be attributed to large-scale selling of bonds from Puerto Rico, sparked by several unfavorable press reports. In addition, the emergence of buyers in early September—when many yields reached multiyear highs—and the rally following the Federal Open Market Committee (FOMC) meeting helped all sectors, including BBBs, post positive returns in September.
Mortgages significantly outperformed Treasuries in September, probably because Treasuries had the most to lose if Fed purchases were scaled back. The onset of those purchases caused spreads in mortgage-backed securities (MBS) to narrow significantly, and expectations of Fed tapering caused those spreads to widen. They narrowed again after the FOMC meeting, boosting MBS returns for the month.
A return of the risk-on trade was evident in the corporate bond market last month. The high-yield market appeared to be headed for a second consecutive quarter of negative returns, but it rallied strongly after the FOMC meeting. The investment-grade market was helped by a strong demand for Verizon bonds, demonstrating that, at relatively generous yields, many potential investors will buy corporate bonds. The demand for Verizon prompted additional buying in all segments of the market. Unlike in the municipal market, the BBB credits continued to record the best returns in September, in the quarter, and year to date.
The longest Treasury bonds have now recorded negative returns for three consecutive quarters. The yield curve steepened as yields rose last quarter, especially in the 10- to 30-year segment, but the rally following the FOMC meeting allowed that segment to eke out a small positive return. Treasury Inflation-Protected Securities also recovered somewhat—enough to produce a positive return of 0.6% for the quarter. Year to date, however, that sector has a return of -7.4%.
Perhaps the best news in the bond markets in September was the emergence of buyers even before the FOMC announced there would be no tapering. The yield levels that were reached early in the month were some of the highest in two years. In the municipal market, yields had almost reached the highs seen in early 2011 and were well above yields on comparable taxable notes and bonds. The response by investors to the values in the corporate and municipal markets was especially encouraging, as it suggested that the yield levels reached prior to the FOMC meeting might be viable once the Fed asset purchases are scaled back.
Table 1: Year-to-date bond market total returns (%)
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 three months, we think investors may still be rewarded by looking at higher-yielding fixed-income investments as well as growth-oriented equities.
EquitiesGlobal equities still look attractive from a valuation perspective. There are risks, as the economic recovery is still middling at best. But pessimism is already priced into stocks, especially European equities. Emerging markets are attractively valued, but the sector is likely going to tell two different tales: Commodity-oriented emerging markets could get cheaper, while manufacturing-oriented emerging markets could begin to recover.
Value versus growthChoosing between value and growth is like choosing between walking to the store and breathing. Why not both? We think pessimism about the future—of which there is plenty—has contributed to mispriced growth opportunities that blend value and growth characteristics.
Large caps versus small capsLarge-cap companies are probably better positioned for global growth than small-cap companies. That doesn’t mean small- and mid-cap companies should be ignored. However, we think it’s more important to be discerning about the economic exposure of a company rather than judge it solely on its size.
Fixed incomeBased on our economic outlook, we believe interest rates are likely to remain low for the balance of the year. This presents an opportunity for investors to take on additional duration and credit risk, but we prefer more credit risk to more duration risk. Provided the economy doesn’t 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 table*Neutral positioning for equities is the percentage of market capitalization meeting the classification criteria of a broad market index. Because the fixed-income market tends to be dominated by sovereign debt, we chose to represent the neutral weight as 50%. The strategic positioning represents our guidance for investors with a time frame of three years or longer. The tactical positioning in the pie charts below represents our guidance for investors with a time horizon of less than one quarter.
The bottom line
October is the time when leaves fall, the air chills, and children around the U.S. go door to door begging for sweets from strangers. They will probably tell stories of ghosts, ghouls, and boogeymen to scare each other. October will likely be a month in which politicians and soothsayers tell investors scary stories, as well. Please remember, though, that in our opinion, these are just stories and nothing to be afraid of.