Market Roundup - November 2013
Big Mo-vember?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
When you mix November with growing moustaches, you get Movember. It’s a movement to raise awareness for various male cancers. Big Mo—which stands for big momentum—is a term that originated in the 1960s to describe the importance of momentum in sports. A team on a winning streak was said to have momentum that could serve as a psychological motivator for better performance. The term has also been used in investing to describe the momentum that’s generated when winning begets winning. Will November see some Big Mo or a big stumble for the markets? We think there may be some trip-ups, but nothing to skin any knees or sprain any ankles.
The economyBy Brian Jacobsen
The partial government shutdown of October 1–16 ended with a deal to suspend the debt ceiling until February 7 and to fund the government until January 15. Superficially, it looks like the debacle has been deferred for a mere couple months. But the Republican image got so tarnished in the fight, and thanks to the extraordinary measures the Treasury can take, the debt ceiling may not really need to be raised until this summer. What we may see is a continuing resolution passed in January to fund the government for six months. If this is the case, the debt ceiling would have to be raised again in June or July, which would be really interesting because the debate would occur in the midst of midterm election campaigning.
The economy seems to have weathered the fury out of Washington. Consumer confidence and sentiment dipped, but that’s likely transitory. Confidence should rebound in time for the all-important holiday shopping season. Business confidence, as measured by purchasing manager indexes, didn’t miss a stride—it continued advancing nicely. Even the economic momentum didn’t seem to change in October. It’s still slow growth.
The Federal Reserve (Fed) has cleared the way to begin tapering any time between December and March. The policymaking body will change in 2014, with more asset purchase skeptics becoming voting members. That could make it easier for Chairman Bernanke, who will likely be replaced by Janet Yellen, to set the ball rolling on how the slowdown in asset purchases will progress at the December meeting. Sure, that could create some market volatility, but not necessarily anything that will be a game changer for what we see as the best investment opportunities.
There are encouraging signs out of Europe and China. In Europe, the European Central Bank will likely provide additional liquidity to the financial system through a long-term refinancing operation, giving big banks ample liquidity at low rates for the long term so that they will have the opportunity to expand credit. The low rates in Europe haven’t been stoking inflation because regulatory policy has been working at odds with monetary policy. It’s hard to generate an expansion in credit and money supply when banks are recapitalizing. But recapitalization may be coming close to an end, which may open the way for the expansion of credit to begin.In China, the Third Plenum runs November 9–12. Top officials will gather to lay out a plan for the next decade. This will be important to follow. Another spurt of growth could result if reforms are made to the property ownership system, giving people more rights to their property and getting rid of residency requirements that preclude people from moving from rural areas to urban areas. These reforms could transform China. England had to go through the enclosure movement (creating private property) in the 15th century and then the Glorious Revolution of 1688 (making parliament supreme over the monarchy), leading to the industrial, agricultural, and scientific revolutions. What took 300 years for England and the West could be compressed into a few decades for China.
EquitiesBy John Manley
Let’s see … Cyprus did not destroy the eurozone. We didn’t bomb Syria. The Fed kept buying billions of dollars of debt a week, and the U.S. government chose to pay its bills on time. No pigs were seen flying either.
The U.S. equity market has cleared quite a few hurdles in the past six months to finish the third quarter close to all-time highs on many indexes. The issues that vexed us were ones that few could have imagined five years ago, yet they all seemed crucial and critical at their appointed time.
In outlasting these challenges, American stocks did something that they have seldom done in the postwar decade: They rose both in September and October of the same year. They were like the Red Sox of the financial world, beating the jinx and overcoming their own fears.
That reduction of fear is a bit worrisome to us over the short term. Rising markets need investors capable of changing their minds. They need walls of worry to ascend. While the longstanding dread of the long term remains beneath the surface (“sooner or later, we are all going to have to pay for the excesses of the past 30 years”), a superficial sense of relief and an accompanying sense of invulnerability are also apparent, after so many trials undergone in such a short period of time were survived.
I believe that veneer will erode with the next 5% to 10% pullback. Good economic news may be inferred to be a harbinger of tapering, and tapering from the Fed could be viewed as constraint. The latter would not be true, in my opinion, but the thought of it could bounce us around a bit and sharpen the bull’s horns.
Retrospectively, the S&P 500 Index gained 4.6% in October on the end of the federal government shutdown and the avoidance of a default. Individual fundamental shortfalls hobbled the narrower Dow Jones Industrials, which only rose 2.9%. The Nasdaq’s gain of 4.0% was also subpar. But none of these results were at all shabby.
No real performance gap was evident between the Russell 3000® Growth Index and the Russell 3000® Value Index. The former rose 4.2%, the latter 4.3%. Big was a bit better than small, as the Value Line Composite Indexes’ appreciation of 3.1% (Arithmetic) and 3.5% (Geometric) were noticeably below that of the S&P 500 Index.
The sector performance reflected the relief rally in the long end of the U.S. Treasury market. By far, the best-performing sector was the high-yielding telecommunication services sector, which rose an impressive 8.5% and recaptured its losses of the prior two months. The consumer staples sector was next, with a 6.4% gain. It seems to have benefited from a weaker dollar and worries about domestic economic weakness induced by the government shutdown. Despite these concerns, the industrials sector (which we overweight) managed to beat the market with a 5% advance. Information technology, where we recommend maintaining a double overweight, performed in line with the market or a small bit above.
The most noticeable laggard was the financials sector. In our opinion, the area’s 3.3% gain was constrained by the continuance of a harsh regulatory environment that we believe will continue for some time.
The emerging markets were a mixed bag, with both laggards and leaders. China’s market dropped more than 1% in local currency and dollar terms. However, India was up a little less than 10% in local terms and more than 10% in U.S. dollars. Argentina continued its recent strength by gaining about 8% locally, but it gave a bit back on its weak currency. Both Brazil and Mexico rose in local currency but lagged the S&P 500 Index. We believe that emerging markets will continue to trade in line with individual national fundamentals in the near term. However, we believe that, in general, it is still too soon to make a major commitment.Developed markets gained strongly in October and generally beat the S&P 500 Index. Italy was particularly strong, with more than an 11% gain, and Spain was close behind, with an advance of 8.9%. Greece jumped close to 18%. It would appear that Europe and, in particular, the Mediterranean are putting their problems behind them. We find developed Europe to be cheaper than the U.S. and to be enjoying a sharper improvement in fundamentals. This could continue for some time, in our opinion.
Fixed incomeBy James Kochan
October marked the second consecutive month of positive returns in the bond markets—a rare occurrence this year. The recovery from the tapering scare began in mid-September and continued through October. The yield on the benchmark 10-year Treasury note rose almost 150 basis points (bps; 100 bps equals 1.00%) from April through early September and then declined 50 bps in the past six weeks.
As is typical during a period when the risk of higher rates recedes, the best performers in October came from the riskier segments of the bond markets. In the investment-grade corporate market, the BBB sector outperformed the higher grades by approximately 0.50%. The high-yield corporate market recovered impressively in October, thanks to a resumption of strong inflows to mutual funds. Within high yield, however, the CCC credits stopped outperforming the BB and B segments, perhaps because the weakest credits had rallied most over the past three years.
Among Treasuries, the long bond finally outperformed in October but by a relatively slim margin. The exceptional steepness of the curve from 10 to 30 years would suggest that the longest bonds should continue to perform best, as long as yields remain within the ranges seen in recent weeks. The Treasury Inflation-Protected Securities (TIPS) remained some of the poorest performers through October. The monthly return of 0.63% lagged that of the 10-year note, and the year-to-date return of -6.80% is significantly worse than returns on similar duration notes. The low year-over-year increases in the Consumer Price Index are keeping the principal adjustments on the TIPS relatively small.The municipal market also recovered for the second consecutive month, with the BBB credits performing best. In earlier months, poor returns from the BBB segment were due primarily to weakness in Puerto Rican names. Another indication of a more rational market was the outperformance of the longer maturities. Because yield curves are exceptionally steep, maturities of 10 years and longer consistently performed best—until the May through August sell-off—then, in October, the longer maturities recorded total returns of approximately 1% versus returns of less than 0.5% for the 1- to 5-year maturities. Because tax-exempt mutual funds continue to experience net outflows, the recovery in municipal bonds has lagged those in the taxable sectors, giving municipal fixed income the best relative values in the domestic fixed-income arena.
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 equities, whether growth or value.
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
Rarely do we get back-to-back monthly gains in September and October, but this year, both were decent months for investors. While investors seem to be on bubble watch—thinking that record highs can’t be sustained—this time, we think the market climate is truly different. This is not a dangerous claim. The real danger is not recognizing that the markets have changed. What’s different now? The answer is profits. Companies are making them, and stock prices are built on them. Markets have likely already adjusted to the inevitable beginning of Fed tapering (December? January? March? Does it really matter?). Investors have also likely grown numb to the constant bickering and showmanship in Washington, D.C. However, changing expectations of near-term growth of corporate earnings could provide better entry points into equity markets.