Market Roundup - August 2013
August: Don’t get psyched outBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
A lot of investing is driven by psychology and perceptions. Fundamentals such as earnings, interest rates, and the economy matter, but investors’ perceptions of those fundamentals matter all the more. Perceptions are not always correct. Often, when you see large or erratic moves in the markets, it’s probably due to dramatic changes in perceptions, not dramatic changes in the fundamentals. The May and June moves in the equity markets might have made some investors emotional or nervous. The idiom “Don’t get psyched out!” seems to be good advice for any investor.
The economyBy Brian Jacobsen
We are now richer than we thought we were. At least that’s what the U.S. Bureau of Economic Analysis (BEA) has told us with its revisions to gross domestic product (GDP) data going back to 1929. Economic statistics tend to improve with age, as we often get more complete data about what happened in the past and, over time, develop better ways to put the data together. The BEA, which periodically revises its past measures of the economy, made revisions in July 2011 that showed that the economic decline was much worse and the recovery was much weaker than originally reported, precipitating market volatility. In July 2013, the revisions included more effective measurements of investment spending, including intellectual property (patents, copyrights, and so on) as investments. As a result, the level of real GDP (GDP after adjusting for price increases) increased approximately 3.4% per year. The growth rate of real GDP didn’t change much, but at least the level improved.
Growth is still painfully slow. The average growth rate of real GDP from 1929 to 2012 was 3.3%. The growth of real GDP during the recovery (the second quarter of 2009 to the first quarter of 2013) has averaged 2.2%. Growth has been slow, but it hasn’t been consistent. In the fourth quarter of 2011, real GDP growth was 4.9% at an annualized pace. In the fourth quarter of 2012, growth was a mere 0.1%. First-quarter 2013 GDP growth improved to 1.1% and improved again to 1.7% in the second quarter, at least according to the advance estimate. We expect that second-quarter GDP will be revised downward, with revisions to inventory and export numbers. When the revisions are down, we could see the first half of the year averaging 1.5% GDP growth.
Sales and production of new cars and trucks have also been strong, and that sector is likely to remain a source of growth in the months ahead. However, consumer spending apart from cars and trucks remains spotty. Household incomes are increasing because employment is increasing. Wages and salaries, on the other hand, are essentially stagnant, so growth in incomes remains far from robust.Housing has been a key source of growth, but a one-percentage-point increase in mortgage rates has apparently reduced some activity. Mortgage applications have weakened significantly—mostly for refinancing mortgages—and sales of existing homes have slowed. If housing is to continue to be an important source of growth, sales and starts data need to rebound. The Federal Reserve (Fed) is keenly aware—or, at least, is becoming keenly aware—of how important low-interest-rate mortgages are to the housing market. After the June 19 Federal Open Market Committee (FOMC) meeting, investors seemed to price in an imminent tapering of the Fed’s asset purchases. Those expectations have likely changed with the release of the July 31 FOMC statement, in which the Fed indicated that inflation may be too low and mortgage interest rates too high. As we have said before, don’t fear the Fed—it seems to have investors’ backs.
EquitiesBy John Manley
Investors who sold in May and went away seem to have missed a pretty good July. Rebounding sharply from a 5% to 10% correction in the previous two months, the U.S. equity market stormed back in July and closed at or near new highs for most indexes. The highs may have been new, but the stories behind them were not.
They were the same three stories that have been driving stock prices higher for more than nine months: reasonable valuations, decent earnings growth and surprises, and continued positive monetary pressure from the Fed. While these elements may not sound glamorous or exciting, they have been the big three for equity performance over the past half century. When they are present, stocks tend to go up, especially if investor sentiment is deeply skeptical. I believe that the May/June correction revealed the distrust and uncertainty lurking in many investors’ psyches—just beneath a thin veneer of hope.
Perhaps the biggest surprise to investors as the second half of 2013 began was how little things had changed from the first half of 2013. In my opinion, prices are higher—but not so expectations. I think that the forces that drove stocks higher in the first half are still with us today and that valuations remain reasonable. Should we expect a different result this time?
Last month gave us a good start to the second half of the year. The S&P 500 Index returned 5.1%, as money pushed in from the sidelines. The high-capitalization Dow Jones Industrials were a bit behind, with a 4.1% gain, but I suspect few people were complaining. The fact that larger-cap technology did well can be inferred from the 6.1% gain posted by the tech-heavy Nasdaq Composite.
The rally appears to have been fairly broad-based, with small-capitalization stocks leading the way. Both Value Line Indexes outperformed the S&P 500 Index, with the Value Line Geometric Composite Index up 6.0% and the Value Line Arithmetic Composite Index up 6.4%. There did not appear to be a preference toward growth or value. The Russell 3000® Growth and Value Indexes both returned a healthy 5.5%.
Health care was the best-performing sector in the S&P 500 Index, with a total return of 7.3% in July. The 29% gain year to date puts the sector in first place for that time period as well. We continue to find this sector attractive, though valuations are no longer the bargain they were two years ago. While we suspect that we are late in the game, we believe that this area can still benefit from an increase in government-funded health care spending. The industrials sector was second best in the month, with a still-impressive 5.7% gain. We believe that this sector is also attractive. In our opinion, it should benefit from both the economic and market rotation that we believe to be occurring.
Most of the other sectors were closely grouped in their performance. We were a bit disappointed at the slightly subpar 4.2% performance posted by the information technology sector. We continue to believe that the corporate upgrade cycle will eventually lift this area. We were not surprised by the meager 0.2% return posted by the telecommunication services sector. We are recommending an underweight to both that and the utilities sector on the bases of their bond-like characteristics, unattractive valuations, and lack of cyclical exposure.
Overseas, a mixed picture emerged, as developed European markets climbed more rapidly than their U.S. counterparts. Emerging markets and Japan lagged significantly. Italy, France, the U.K., the Netherlands, and Spain all posted better gains than the S&P 500 Index in local currency terms. The stronger euro boosted these gains even further and turned Ireland, Greece, and Germany from laggards into outperformers. We sense that, finally, Europe may be reaching the end of a long and dark tunnel. It may be too soon to call for European equities to take the lead, but we suspect that the markets there are changing for the better.That would be good for the U.S. and, perhaps, even better for emerging markets. However, as of last month, emerging markets showed few signs of an equity recovery. China’s equity market rose less than 1%, while India’s—like Japan’s—actually fell slightly. Russia gained 3% and Brazil and Mexico, less than that. We realize that emerging markets have offered returns in excess of the U.S. market over the long run, and we realize, too, that they have lagged significantly over the past 6 to 12 months. While we believe that any stabilization in Europe would be a plus here, we continue to suspect that it is too early to make significant commitments in this area.
Fixed incomeBy James Kochan
While the corporate market recovered somewhat during July, other sectors, notably municipals, continued to struggle. Investors appeared to resume their quest for yield in the corporate market, as the weaker credits recovered most. Among the investment-grade corporates, the BBB credits once again performed best. That had been the pattern until the May–June sell-off. During that sell-off, the A and AA credits performed better. Year-to-date returns are still substantially better for the BBB credits. Bank paper has been outperforming all year, and that continued in July. The banking sector had nearly a 1.0% return in July and has a much smaller negative year-to-date return than the full investment-grade market.
Inflows to the mutual funds and exchange-traded funds helped the high-yield market recover from two months of negative returns. In July, the weakest credits performed only slightly better than the B and BB segments. But year to date, there is a big performance differential in favor of the CCC and weaker segments. On average, yields declined 30 to 40 basis points (bps; 100 bps equals 1.00%) from the highs of early July but remain 75 to 100 bps higher than the lows reached in April.
The municipal market was recovering slowly during the first half of July, but the Detroit bankruptcy news set off another round of outflows from tax-exempt bond funds. As a result, the municipal market was the poorest performer in July and now shows the weakest year-to-date returns. The longer maturities and the weaker credits have been hurt most by the latest selling pressures. While the 1- to 3-year maturities still show positive year-to-date returns, the 10-year and longer maturities did not. Except for a few weeks in December 2010 through January 2011, municipal yield curves are now steeper than they’ve been at any time in the past 20 years. For maturities of 10 years and longer, AAA yields are well above Treasury yields. Yields on 10-year A rated general obligation bonds are now 1.5 times the Treasury yield—far above the precrisis average of around 0.9. By almost any metric, municipals now offer unusually generous relative values.
The Treasury yield curve is also unusually steep. Fears of an early reduction in Fed purchases caused all yields to rise, but with the federal funds rate stuck near zero, the yield increases were much less in the shorter maturities. The 2-year yield is now approximately 15 bps higher than it was in late April, while the 30-year yield is approximately 75 bps higher. When curves are this steep, the intermediate and longer maturities typically outperform the shorter maturities, especially when short-term rates are likely to stay low for an extended period.
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.
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*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 lineThe possibility of disappointing growth in the second half of the year (sub 2.5% real GDP growth) could create more market volatility, but the Fed’s accommodative rhetoric and actions should help cushion the downside. We think the May/June moves in the markets were reminders of why investors should stay diversified and keep focused on their longer-term goals. If you need cash in the next couple months, you might not want to put it in a market that not only goes up but can also go down. People seem to be shifting their perceptions about the fundamental state of earnings, so staying diversified and keeping focused on long-term results while others are reacting to short-term news can help keep you from getting psyched out by the markets.