EmailThe stock market has gotten off to a roaring start in 2013, bolstered by a number of Rolaids factors that have spelled relief.
Congress struck a begrudging deal on tax rates that kept the economy from feeling the full force of going over the fiscal cliff. A contentious debt ceiling debate was deferred until mid-May. Fourth quarter earnings came in better than expected. And a body of economic reports was released signaling a pickup in home sales, business spending, consumer spending, and job growth.
Phew.
No factor, though, has provided more relief than the understanding that the Federal Reserve seems likely to stay the course with its accommodative policy for some time yet.
The Bernanke put, the Fed put, or whatever you want to call it, has been the ultimate confidence booster for market participants surfing the liquidity wave. The S&P 500 has surged 9.3% year to date -- and it's not even the best-performing average. That distinction goes to the Dow Jones Transportation Average, which is up 18.0% year to date.
We get the excitement and understand that there can be a large opportunity cost in trying to fight the Fed. There is a basis for buying into the stock market on that reason alone. Furthermore, valuations are not excessive and economic trends in the US appear to be improving -- also reasons for buying into the stock market.
In brief, it is not a cash-out environment when the Fed is all but imploring investors to buy stocks with its policy of interest rate suppression. That doesn't mean, however, that it is a risk-free environment either.
Controlling investment portfolios for risk should always be a guiding principle for any investor, particularly since plenty of risks remain that can upset this bull market.
Risks, They Do Exist
We are not altogether surprised by the stock market's strong start. We noted in our last Market View update that there was a decent chance the market would rally in the early part of the year if worst-case scenarios, like falling off the fiscal cliff fully or hitting the debt ceiling, were removed.
The debt ceiling issue of course hasn't been removed, just deferred. Nonetheless, that deferral was taken in stride as a short-term, moral victory for the bulls during the first quarter.
The debt ceiling will be back in focus in mid-May when it will need to be addressed, although extraordinary measures taken by the Treasury could perhaps push the real deadline into July. The overarching point is that policy risk remains alive and well with partisan politics impeding necessary spending reform, tax reform, and entitlement reform efforts.
Ratings agencies have signaled that they could downgrade the US credit rating if credible plans to bring the nation's debt under control aren't agreed to soon.
We suspect a lot of participants aren't overly concerned about a downgrade knowing that the stock market, with help from the Fed, bounced back relatively quickly from the 19% correction in the S&P 500 that followed the debt ceiling debacle of 2011. Such complacency is a risk in and of itself.
Other risk factors that should be considered include the following:
- The potential that future economic reports show weakening trends stemming from the lingering effects of higher tax rates, higher gasoline prices, and the sequestration.
- A government shutdown in the event Congress can't reach agreement on a continuing resolution for the current fiscal year
- An earlier-than-expected withdrawal of Fed stimulus
- A spike in interest rates
- An increase of social rebellion in the eurozone that is rooted in extremely high levels of youth unemployment
- A political vacuum in Italy that drives up borrowing costs and creates dislocations in financial markets
- Tightening efforts in China to keep inflation and property speculation under control that in turn produce lower-than-expected growth
- Currency debasement that invites higher inflation and protectionist policies
- Geopolitical conflict in the Middle East and/or East Asia
- An actual decline in earnings growth
- The accelerated use of margin debt and the large deficit in margin account credit balances that are signs of increased speculation
A list of risk factors is typically presented at the end of a report like this. We purposely chose to lead with it here, though, to drive home the point that, contrary to popular belief, market risk is ever present in spite of -- and maybe time will tell because of -- the Fed's easy monetary policy.
In the Loop
With the hot start to the year, it was rather ironic that the advance estimate for Q4 GDP, reported at the end of January, indicated economic activity contracted 0.1%. The second estimate ultimately resulted in an upward revision to 0.1% growth.
The very weak growth in the fourth quarter didn't faze the market. After the tax rate deal averted the full fiscal cliff, the market ran with the notion that fiscal austerity will be a drag in the first half of the year but that growth momentum will accelerate in the second half of 2013.
A series of incoming reports has helped substantiate that view, none more relevant arguably than the downward trend in initial claims, which is a leading indicator.
Job growth that leads to income growth is an essential component of any economic growth story since it creates a positive feedback loop. Higher job growth leads to higher demand that encourages increased business investment, lending activity, and consumer spending.
The charts below provide a snapshot of why many participants believe better times lie ahead.
Earnings Estimates Too High
Our 2013 GDP forecast entering the year was for growth to be between 1.0% and 2.0%. That forecast was predicated on the belief that fiscal austerity measures would curtail growth by at least 1.2 percentage points. The data we have seen thus far leads us to think growth will now be between 2.0% and 2.5%.
Simply put, fiscal austerity has yet to bite as we thought it might. In the same vein, earnings growth has also been better than expected.
Fourth quarter earnings increased 4.0%, according to FactSet, versus a 2.0% growth rate that was projected before the reporting period. Another striking feature of the fourth quarter reporting period, though, was the abundance of earnings warnings issued for the first quarter.
The FactSet earnings summary indicates that 107 S&P 500 companies issued guidance for the March quarter. Out of that total, 82, or 77%, issued negative guidance, which is well above the five-year average of 61%.
In conjunction with the guidance, first quarter earnings growth estimates have been revised down from 2.2% on December 31 to a decline of 0.6% today. If history is any guide, first quarter earnings will end up better than expected.
The fundamental paradox is that the S&P 500 price index has surged 9.3% since December 31 while the first quarter earnings growth estimate has been revised to show no growth. At the same time, the second quarter earnings growth estimate has been reduced to 4.9% from 6.3%.
The 2013 earnings growth estimate has been cut to 7.9% from 9.3%, yet that belies the fact that third quarter and fourth quarter earnings growth estimates remain a lofty 10.1% and 15.7%, respectively. Remarkably, those earnings growth projections are matched with revenue growth projections of just 4.6% and 1.9% for the same periods, according to FactSet.
Earnings estimates for the back half of the year are likely to be revised lower.
The hockey-stick earnings growth forecast, however, is typical on Wall Street and fits neatly with the conventional wisdom that economic growth momentum will accelerate in the second half of the year.
Yield Signs
The top-down calendar year operating earnings estimate for the S&P 500 is currently $108.10. At its current level, the S&P 500 is trading at 14.4x CY13 earnings. That is not excessive, but we also don't think it is entirely credible since the CY13 earnings estimate is likely to be revised lower.
On a trailing twelve-month basis, the S&P 500 trades at 15.4x earnings. That is roughly in-line with the historical P/E multiple for the market. Then again, over the last 25 years inflation has averaged 3.0% while the 10-year Treasury yield has averaged 5.4%. Today, both inflation and the yield on the 10-year note are at 2.00%.
The latter is the basis for why many pundits still view the market as being cheap even though the earnings multiple is back near its historical average.
The earnings yield (the inverse of the P/E) is really more instructive on the matter of relative valuation, and what it indicates today is that stocks hold better relative value than Treasuries at current levels for long-term investors.
The forward earnings yield is 6.90%. That is nearly 500 basis points above the 10-year note yield and compares favorably to a 10-year average spread of 340 basis points. In this light, there is ample basis for long-term investors to be putting money to work in the stock market.
A Cautious Bull
It has essentially been a bull run for the market so far in 2013. There have been only three sessions in which the S&P 500 has declined more than 1.0% and it has risen in 66% of the trading sessions since the start of the year. That performance has placed it at the doorstep of new record highs that have already been established by the Dow Jones Industrial Average, the Russell 2000, the S&P 400 Midcap Index, and the Dow Jones Transportation Average.
The advance has been remarkable, but it has also been somewhat perplexing. The rally has occurred on relatively light volume, it has been accented with the outperformance of the countercyclical health care and consumer staples sectors, and it has seen both oil and copper prices weaken into the advance. These factors suggest there is lingering doubt about the growth outlook and the sustainability of the stock market rally.
At the same time, the financial, consumer discretionary, and industrials sectors have also outperformed the market, the transportation and semiconductor stocks have been on fire, volatility has collapsed, and bond yields have backed up 25 basis points. These factors suggest there is confidence in the growth outlook and in the sustainability of the rally.
Only time will tell which viewpoint prevails, but the battle of outlook wits speaks to the recognition that the liquidity support provided by the Federal Reserve is underpinning financial markets, but remains deficient still in fostering strong growth in the real economy.
The future path of economic data, therefore, will be an important driver as the rest of the year unfolds.
What It All Means
We are admittedly encouraged by recent trends in the economic data, and labor trends in particular. Still, with the overhang of higher taxes, the partisan divide in Washington, the lag effect of sequestration, weak business activity in the eurozone, and efforts by China to tame rising inflation, we are not convinced yet that second-half growth will live up to heightened expectations.
Accordingly, we continue to emphasize the importance of risk control in the face of a Fed-led rally that is defensible and at the same time delusional.
The market can stay overbought for a lot longer than one might think when the Fed is endorsing easy monetary policy. One mustn't forget though that complacency and speculation typically rise as well during such periods, and when the music stops, or there is an exogenous shock outside the Fed's control, stock prices can correct in a hurry.
Don't be unprepared for the unexpected.
Some general approaches for investors aiming specifically to guard against downside risk for their equity portfolio include:
- Hedging through the use of options
- Reducing exposure to high-beta stocks and/or stocks trading well above long-term moving averages
- Favoring stocks in countercyclical sectors (eg. health care, consumer staples, utilities, and telecom services) that typically exhibit better relative strength in volatile periods
- Owning companies with strong balance sheets and the capacity to increase dividends in any environment
- Buying shorter-duration bonds and
- Raising cash
