April 1 brings the opening of the major league baseball system, a raft of weird April Fools' gags perpetrated electronically by the geeks in Silicon Valley, and a dose of agita to the average investor. In the initial second quarter of this bull market run begun in March 2009, stocks enjoyed the strongest second quarter since 1996, appreciating 15.2% on the S&P 500. Since then, however, stocks have struggled in the second quarter.
In the second quarters of 2010, 2011, and 2012, stocks averaged a 5.6% decline on the S&P 500. Each of these periods have been different, reflecting different macroeconomic forces and resulting in different (though all negative) index outcomes. The "best" of the bunch, the second quarter of 2011, led into the worst third quarter since 2002.
First quarters in the 2010-12 timeframe have averaged 7.7% capital appreciation on the S&P 500. The recent spring quarters have begun by carrying optimism over from those rallying first quarters. For the three Aprils of 2010-12, the S&P 500 averaged 0.9% appreciation. But there is the reason the old maxim goes, "Sell in May…" rather than "Sell in April." The three Mays of 2010-12 averaged a 5.2% decline on the S&P 500. The Junes were better, but not by much; Junes in the preceding three years averaged a 1.4% decline on the S&P 500.
The second quarters since 2009 have had decline in common, and all have been bedeviled by a combination of economic pause and government policy impacts, both here and abroad. But the combination of factors has been distinct in each period.
In spring 2010, following a 5.7% first-quarter gain, investors first learned of the sovereign debt crisis in Europe. The Deepwater Horizon rig blew up, unleashing the Gulf oil gusher which darkened the national mood. Investors and the public learned how deeply divided Washington had become, as efforts to pass Dodd-Frank and the Affordable Care Act split the nation and escalated the acrimony between the two parties.
In spring 2011, following a 5.4% first quarter gain, Republicans sought to capitalize on their impressive performance in the mid-term elections. As the clock ticked toward the July debt-ceiling showdown, and as the news from Europe worsened, early-quarter gains melted away. The S&P 500 finished down 0.4% for 2Q11. That proved a prelude to the debt-ceiling debacle, when the S&P 500 plunged 18% in the final week of July and the first week of August 2011 and barely missed the bear market designation.
In spring 2012, investors figured this time it had to be different. The market was coming off a strong six-month performance period spanning 4Q11 and 1Q12. But policy once again intervened. With the President's popularity plunging, the election outcome seemed highly uncertain. As an uncommonly bitter Republican campaign season heated up, and with the expiring Bush-era tax cuts and sequestration looming on the horizon, the S&P 500 declined 3.3% in 2Q12.
Just because the calendar flip for the preceding three years has been so unfortunate, should you assume it will be so again? No. But you should be aware that many investors, both institutional and retail, are very aware of the seasonal pattern in the market (which extends well back beyond 2010). Market bumps and bruises that would be regarded as a buyable dip in December look much more ominous late in April. Fingers start getting itchy on the sell trigger as May approaches.
That said, we are not assuming that a sell-off is predetermined for this quarter. Our firm's Chief Investment Strategist, Peter Canelo, looking out across 2013 rather than at any one quarter, counts four major factors in the equity market outlook this year. Three factors are benign to positive, but the fourth threatens to wreck the equity rally. Based on the first three factors, Peter sees the market moving higher this year; based on the fourth, he expects the equity market to make its high not later than 3Q13 and to finish the year below that high.
The first factor is the domestic and global economy, encompassing both economic activity as well as policy. It is true that policy impacts dogged the mid-year market for the preceding three years. But the most feared policy bogeyman, the fiscal cliff, was reduced to a hillock. The Bush-era tax cuts were allowed to expire, but in severely amended form. Instead of the feared fiscal hit of $2-$3 trillion, higher income tax rates on the wealthy have amounted to about $600 billion. Re-imposition of the full payroll tax to 6.2% for most earners, from the 4.2% level prevailing in 2011 and 2012, has surprisingly been a non-event; a public wearily familiar with belt-tightening just tightened a little more. The sequester was allowed to pass without any intervention - an auto-pilot response to important legislation that is testament to both parties' abdication of responsibility - but has been stretched out to mitigate its worst impacts.
With the fiscal cliff in the rear view, fiscal uncertainty dispelled, and tax policy settled, consumers and business people have cautiously begun to set their agendas. Although store-based retail measures have flattened out since the payroll tax was fully restored, internet commerce (rarely measured accurately) has exploded. The twin engines of the consumer economy, automotive and housing, are rallying. Industrial measures could be stronger (more on that later); but consumers usually lead mid- to late-stage phases of economic recovery.
The second positive factor is earnings. Companies routinely under-forecast and over-deliver, leading to the rote "surprise" delivered in earnings each quarter. While analysts went into the 4Q12 reporting period expecting a slightly down quarter, Bloomberg bottom-up analysis indicates 8% year over year earnings growth for the period. We expect S&P 500 earnings to grow in mid-single digits in 2013, to $111.00, and in high single digits in 2014, to $121.00.
The U.S.-based multinational corporations that account for the bulk of S&P 500 earnings were harshly schooled by the 2001-02 and 2007-08 recessions, and those lessons are supporting earnings. Corporations learned to run lean always, and add more variable than fixed costs in good times. Strong cash generation has reduced debt load; a decade of low rates has reduced debt service. More international business means lower net taxes; and relentless share buybacks further aid the bottom line. These multi-nationals, which have long regarded emerging economies as their fastest-growing markets, have for the past year and half been enjoying the improved business climate here at home in the USA.
We note that S&P 500 earnings at the prior market peak, in 2007, were about $82.00. A 2007-comparable P/E on forward (2013-14) earnings would render an index price north of 1800 for the S&P 500. That brings us the third factor, valuation, which Strategist Canelo calls compelling. Using earnings yield, normalized earnings (three years back, two years forward), or plain old historical P/Es, this market looks to us to be 15%-18% below fair value.
But even an attractively valued market is only as good as the investing environment, which is our fourth factor and the only one that we regard as a real impediment to the ongoing bull market. Within the investing environment, the first negative is dollar strength. The industrial revival of 2009-11 was underpinned in part by dollar weakness, which provided competitive firepower to U.S. multinationals doing business overseas. U.S. presidents routinely proclaim that they "want a strong dollar." But, trust us, Caterpillar (CAT) is not happy about it.
The second and more meaningful negative in the investing environment is the looming shift in monetary policy. The Fed will likely make good on its pledge to keep rates low indefinitely at the short end. But many investors regard the market as "addicted to stimulus," and even a slight change in the quantitative easing (QE) dynamic might doom the four-year-old bull market.
The Fed, which is buying $85 billion of U.S. debt monthly in "open-ended" purchases, has pledged to keep its foot on the QE pedal until unemployment is below 6.5%. While that looked unattainable a year ago, Strategist Canelo now believes the 7.0% level "is a chip shot" and that 6.5%, though a stretch, is doable by year-end.
One day, believe it or not, QE will be in the history books rather than being policy. Will the stock rally crash at that inflection point? Even within this dynamically changed investing environment, we could see some positive outcomes. In the zero-sum game of currencies, the negative for U.S. multinationals of dollar strength is a positive for weak currency regions, most notably Europe and Japan. Both are significant historical trading partners, and both currently represent very poor markets for our goods: Europe for what seems like forever and Japan since regime change in 2012. If euro and yen weaknesses help restore competitive vigor in these end markets, that could blunt the worst impacts of dollar strength (and Caterpillar is still not happy about it).
The deeper negative of dynamic change in monetary policy could be offset by the less-negative-than-anticipated shift in fiscal policy. Everyday consumers are learning to live with the full payroll tax, and the rich…well, they don't seem to be turning in their passports.
Our final thought on the impact of a change in monetary policy relates to asset allocation. Private equity, real estate, and derivatives - these are all real asset classes. But we all know that the two big pools of assets, the Atlantic and Pacific in this game, are fixed income and equity.
Our firm's founder Harold Dorsey regularly lunched with Fed governor William McChesney Martin, who famously said the Fed's job was to "take away the punch bowl just as the party gets going." Martin was referring to raising rates; but canceling QE would equally kill the mood. Even after QE ends, we would not expect the Fed to sell assets off its balance sheet. But even allowing them to run off (mature) would significantly change the dynamic in the asset markets, particularly in fixed income
While the end of QE such an event would annoy equity investors, it might equally trigger the long awaited "great rotation" out of the Treasury market. That flood of cash would have to find a home somewhere. The equity market, even a five-year-old bull market, might be the destination.