Market Roundup - June 2013
June: Anticipating the anticipations of othersBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
The famed economist and investor John Maynard Keynes once said that successful investing involved “anticipating the anticipations of others.” Market prices are determined by the interactions of buyers and sellers, and their willingness to pay or accept a price depends on what they anticipate. This includes expectations of what other investors may expect but also anticipated earnings, interest rates, and changes in government policies. It’s game theory in action—people have different information, and they act on it strategically. Prices reflect their anticipations and prices change as expectations change—and as reality confirms, or confounds, those in the market.
Recently, it seemed as though markets were reacting to fundamentals, such as earnings, but also to shifting expectations of when the Federal Reserve (Fed) may alter its asset purchase program. This is actually a positive trend, because as long as the Fed doesn’t act out of the blue, the markets will likely adjust to and adapt to whatever the Fed does next, with little market disruption. Whether the Fed tapers its asset purchase program soon probably doesn’t matter as long as it telegraphs what it is going to do. We don’t think the Fed is going to taper anytime soon. For those who fear the tapering, we recommend that you take a breath—and don’t let your fears upset your portfolio allocation. It’s likely the Fed will actually increase its asset purchase program before it starts winding it down.
The economyBy Brian Jacobsen
The U.S. equity markets continued their ascent as earnings release after earnings release seemed to beat expectations. For the S&P 500 Index as a whole, 66% of companies beat the consensus earnings expectation for the first quarter. Revenues were on the light side, with less than half of companies beating expectations and sales per share declining from the fourth quarter of 2012 to the first quarter of 2013. Of course, sales per share in the fourth quarter were nearly $10 higher than the previous peak in the second quarter of 2008. Perhaps that partially explains why the market hit all-time highs during the month of May.
June could prove to be a more volatile month for the markets than May. On June 19, the Federal Open Market Committee (FOMC) will release its policy statement and Chairman Bernanke will hold a press conference. When FOMC meetings are associated with a press conference, opportunities are ripe for a shift in policy because the chairman can expand on what the Fed is doing and why. The next two meetings followed by a press conference are scheduled for September and December, and along with June, these are the ones investors should be paying close attention to.
June, we think, is too early for the Fed to begin tapering its asset purchases. The Fed has been taking credit for the housing recovery, so it will likely take responsibility for keeping mortgage interest rates low. With a 30-year conforming mortgage rate hitting a one-year high of 3.81%, the Fed may be inclined to expand its purchases of mortgage-backed securities instead of trimming them. It’s also hard to argue that the labor market has shown the significant and sustained improvement that the Fed is looking for.
Before the FOMC meets, Iranians go to the polls to elect a new president. On June 14, the world will likely know who takes over the presidency from the controversial and antagonistic President Ahmadinejad. President Ahmadinejad won his second term in 2009 in a controversial and allegedly rigged election. He is barred from running again, so the question on many people’s minds is whether one of his allies or a reformer will win. The Guardian Council, a group tasked with approving candidates, has effectively guaranteed that reformers will not fare well by blocking most of their candidacies. Thus, it is likely that a president who is sympathetic to the policies of the Supreme Leader Ayatollah Khamenei will be elected. Of the approved candidates, most—if not all—at least appear to be less polarizing than the outgoing Ahmadinejad. That could help push oil prices down and be a boost to risky assets.
A third reason markets could be choppy in June is anticipation of the elections in the upper house of parliament in Japan, to take place on July 11. Shinzo Abe got a second shot at being prime minister and has pledged to pursue three areas of reform: expansionary fiscal policy, expansionary monetary policy, and the regulatory environment in Japan. Thus far, pledges to invest in infrastructure have been made, and the Bank of Japan has embarked on an aggressive qualitative and quantitative easing program. The next phase—regulatory reform—is the hardest and most important if the slumbering giant of Japan is to awaken. Shinzo Abe’s reforms, sometimes called Abenomics, could live or die with the election in July. We think it is likely that his Liberal Democratic Party will win a majority in the upper house, but perhaps it will not be as resounding a victory as his party won in the lower house. That could draw into question the stickiness of the reforms: After three decades of recession, Japan needs big and lasting reforms.
EquitiesBy John Manley
The U.S. equity market might have ended May with a thud, but the whole month could be considered to have been more of a continued roar. The S&P 500 Index advanced 2.3% in the period, despite a falling bond market and decided weakness in the early-cycle stocks that had dominated the first three months of the year. The Dow Jones Industrial Average advanced 2.3%, and the technology-laden Nasdaq Composite was up a healthy 4.0%. Early upward momentum seemed to fade as the month progressed, and the trading action in the last week was choppy by comparison.
To us, the most prominent feature of May was the rapid rotation out of traditionally high-dividend-yielding sectors toward more cyclical and economically sensitive areas. In our opinion, this is consistent with a classic bull market pattern, based (supposedly) on economic underpinnings. The textbook version of a bull market begins when the Fed decides that current economic activity is anemic and should be stimulated. The Fed pushes liquidity into the economy through monetary stimulus to achieve this. On its way to the economy, the liquidity passes through the capital (that is, equity) market and causes it to rise, even before any palpable success of the program is apparent. Thus, noncyclicals, such as utilities and consumer staples, typically take an early lead. The first part of the real economy to register the positive effect of the stimulus is usually the housing market. That, in turn, tends to spur the American consumer and moves equity market leadership to the consumer cyclicals. As consumers loosen their purse strings, manufacturers tend to expand production and then capacity. At that point, the industrials, information technology (IT), and financials sectors move higher. Only at the end of the bull market, when the capacity strains become apparent, do the late cycle, or commodity, stocks do well.
So far, the bull market of the past six months seems to be following this pattern. Early-cycle stocks seem to be fading as more cyclical, mid-cycle stocks take the lead. To us, this seems to be a healthy sign that the upward move in equities is only in its middle phase.
Last month, the fixed-income market and high-yield, noncyclical equities were in full retreat. The utilities sector plunged 9.1%. The telecommunication services sector was close behind, with a 7.4% drop. Even the supposedly reliable consumer staples sector declined by 2.3%. While these sharp drops may rebound in the weeks ahead, we believe that the first two sectors should be underemphasized going forward and that consumer staples should only be market weighted.
At the other end of the spectrum, the financials sector led the market with a 6.1% advance. While our opinion of this sector has focused too sharply on regulatory issues in the past year, we continue to believe that regulatory shadows will somewhat counteract the otherwise favorable actions of the Fed’s quantitative easing and positive monetary pressure.
Two other positive performers were the industrials and IT sectors. Last month, the former gained 4.9% and the latter advanced 4.6%. We are positively disposed toward both areas. In the case of IT, we see the continuation of a strong technology upgrade cycle in the corporate space. This strong upgrade cycle, combined with historically low valuations and the presence of a number of high-quality companies with strong cash flow and healthy yields, makes for an attractive sector, in our opinion.
The move toward more cyclical names was accompanied by a move toward lower market capitalization as well. Both Value Line Composite Indexes outperformed the S&P 500 Index in May (Arithmetic was up 3.9% and Geometric was up 3.5%). While we continue to like large-capitalization, high-quality names, we suspect that a move toward more cyclical areas may be accompanied by a move down the capitalization spectrum. In addition, an increasing availability of credit at cheap prices could begin to spur more merger and acquisition activity.
Overseas markets tended to outperform the U.S. However, some of the resource markets were exceptions: Australia was down 4.8%, New Zealand was down 2.5%, and Canada was up only 1.8%. European markets generally outpaced the S&P 500 Index, as some early signs of economic stability emerged. China rebounded 5.6% after sharp underperformance earlier in the year. We see all of this as a glimmer of hope on the horizon.
Fixed incomeBy James Kochan
May was a brutal month for Treasuries and markets with average or narrow spreads to Treasuries. The benchmark 10-year Treasury note recorded a total return of -3.7%, the worst performance since December 2010. The 10-year yield rose 50 basis points (100 basis points equals 1.00%) in May, a big move for one month. The -2.0% return for the Treasury market was the worst since December 2009, and the -4.7% return on Treasury Inflation-Protected Securities (TIPS) was the poorest performance since the dark days of September and October 2008.
Markets such as mortgages, where spreads to Treasuries are narrow, and investment-grade corporates, where spreads are about average, also performed poorly last month. The monthly return for the mortgage market was the poorest since 2004. Unless mortgages perform better in June, the first six months of 2013 will show the poorest return since the first half of 1999. Fears that the Fed might soon scale back on its bond purchase program hurt the Treasury market, but they were especially harmful to the mortgage-backed securities (MBS) market, which has benefited more from these purchases.
Because there was relatively little room for spreads to narrow, yields on investment-grade corporate notes and bonds increased as much as Treasury yields. Even in the BBB segment, where spreads are still somewhat wider than average, yields increased in step with Treasuries. Because of the higher yields on those credits, the year-to-date return from BBBs was -0.10%, versus negative returns of -1.0% from the AAA and AA credits.
The power of higher yields was apparent again in the high-yield market in May. Yields increased less than they did on Treasuries but enough to send prices lower. Interest income was almost sufficient to overcome the price effect, and the monthly total return was only slightly negative. High yield is one of few taxable sectors to have a positive year-to-date return.
Greater coupon income also helped the A and BBB segments of the municipal market outperform the stronger credits by wide margins. Yields on AAA and AA municipals increased less than on comparable Treasuries but more than yields on the A and BBB credits. All credit segments had negative returns in May, but the BBB segment returned -0.6%, versus -1.2% for the AAA segment. Year to date, average total returns were 0.1% for the AAA/AA credits and 1.1% for the A/BBB credits.
The May returns are a reminder that interest income, not price appreciation, will probably be the major contributor to total returns in 2013 and beyond. It would probably be a mistake to assume that yields will continue to rise as they did last month because the ingredients for a bear market in bonds—rapid economic growth, capacity constraints, rapid money growth, and rising inflation—are not in place. Nevertheless, when yields are as low as they were at the end of April, there is limited potential for further price appreciation but considerable potential for corrections. Those corrections can eliminate several months of price gains, leaving coupon income as the source of positive returns.
Table 1: Year-to-date bond market total returns (%)
Asset allocationBy Brian Jacobsen
For 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. While there could be an equity market retreat, we don’t expect that any loss will be deep.
EquitiesGlobal equities still look attractive from a valuation perspective. Talk of the Fed tapering its asset purchase program is premature, in our opinion. The economic data just isn’t that strong, and there are deflationary pressures, not inflationary pressures. With mortgage rates rising and the Fed intent on stimulating the economy through the housing market recovery, it’s hard to imagine the Fed contributing to an increase in mortgage rates by cutting back on the pace of its purchases of mortgage-backed securities. Other central banks have been long-term and near-term beneficiaries of these policies. There are risks, as the economic recovery is still middling, at best. It’s possible that the first-quarter growth for the U.S. economy was the high watermark for the year, which could lead to disappointment in the fourth quarter. That’s why we’re encouraging investors not to go all in on equities. Higher-yielding fixed income could be a way to participate in equity market gains while enjoying periodic interest income in excess of what you can get on Treasury securities.
Value versus growth
Choosing 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 caps
Large-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*Understanding the table
The shading on each chart could be thought of as a temperature control in a car. The blue bar represents our recommended tactical positioning for investors with a time horizon of less than one quarter. The green bar represents our recommended strategic positioning for investors with a time frame of three years or longer. The light gray line represents the neutral weight. For equities, this 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 bottom lineGovernments are shifting from an austerity now mantra to an austerity later, growth now mantra, which is a healthy development. Even the usually miserly German government is endorsing this new model. Talk about tightening of monetary policy in the U.S. is being blown out of proportion. Even if the Fed did cut back on its purchases of assets, it would still be providing more liquidity to the financial system and would support expansion, not contraction. If the Fed announces that it’s business as usual, or if it expands its asset purchase program at its June 19 policy release, it may spark a major shift in attitudes and anticipations of the remaining market bears out there. We think it is prudent to shift a portfolio in anticipation of the changing attitudes of others. As the title of this piece reminds investors, successful investing is anticipating the anticipations of others.