May was another good month for the market, the seventh gain in a row for the S&P 500, but it didn't end well. The opposing slopes to May's stock chart - a 70-point rise in the S&P 500 in May's first 20 days, and a 38-point plunge in final 10 days - hint that investors fear the type of summer sell-off we have seen during the past three years.
Even after May's nerve-wracking slide, the major market averages are all up about 15% YTD. That's an above-average return already, with seven months of the year to go. We see a number of signs, however, suggesting the market rally can continue. In our view, a range of favorable technical, economic, fundamental, and asset-class indicators support the ongoing positive outlook for stocks.
Within the domestic economy, the private sector continues to grow, led by consumer areas including automotive and housing. From a fundamental perspective, earnings are still growing, and equity valuations are still attractive. Technically, the stock market is characterized by good market breadth, sector rotation and moderately positive (but not overly bullish) investor sentiment. Late-to-the-party investors show signs of coming off the sidelines. Finally, with interest rates headed up, alternative investments such as bonds appear relatively less attractive.
Let's examine all these factors in turn. The domestic economy and U.S. stock market do not have a one-to-one correlation, but the U.S. remains the most important market for most of these companies. The component companies in the S&P 500, representing more than 80% of U.S. equity market capitalization, derive a third of revenues and more than 40% of income overseas. Moreover, for years U.S. multinationals have derived their best growth in emerging economies. During the domestic recovery, however, Europe has struggled and China has become turbulent. We have been pleased to see the U.S. reemerge as a key engine of S&P earnings growth.
Domestic jobs growth has been solid the past six months, with an average gain of more than 200,000 positions per month. And that's occurring despite cutbacks in government jobs. So the private economy is looking pretty good. We've noticed a lot of volatility in the monthly non-farm payroll numbers, though, including revisions that in some cases have been drastic.
That's why we keep a very close eye on the weekly unemployment claims. In a positive for the economy, the UE claims trend has been more consistently lower since the recovery began in 2009. For example, back in 2009, claims topped out at 600k/week. By November 2009, they were 500k; by December 2010 they were 425k; and they have since worked down to 350k. At the same time, the slope of the decline curve for claims has slowed in recent months. That is likely a sign that unemployment claims are close to reaching their normal state.
On that basis, we are not looking for "break-out" non-farm payrolls gains in the, say, 300,000 range. We forecast steady rather than spectacular numbers, with non-farm payrolls, monthly gains expected to average a solid 150-200K through the summer. On the downside, should weekly UE claims more back up toward 400k, then those monthly payroll numbers may be closer to 100k.
What does the jobs number say about the outlook for domestic GDP growth? With the government MIA, the economy is all about the consumer. And an employed consumer is a good place for economic growth to start.
First quarter 2013 GDP growth was revised down by a tick to a preliminary 2.4%, from an advance 2.5%. Growth was driven by consumer spending (real personal consumption expenditures, or PCE), which advanced 3.4% - up 160 bps from 4Q12 PCE growth of 1.8%. Fixed investment, both residential and non-residential, slowed from strong 4Q12 levels but remained healthy.
Within the longer-term GDP trend, the offsets have been a slowdown in export growth and outright declines in government spending for 11 of the past 12 quarters. In the "can't have your cake and eat it, too" category, investors have gone from a decade-long lament about out-of-control government spending, to wondering why the government isn't spending more to stimulate a growing, but far from robust economy.
We think the mid-2% growth in 1Q13 GDP reflect the impact of tax hikes and budget cuts. It also likely reflects the mixed after-effects of Superstorm Sandy, which may be stimulating the building trades, but has also hampered countless small businesses. As sequestration spending cuts and changes in the tax code become part of the fabric of daily life, we think the GDP numbers will be stronger in the back half of the year, when the growth rate could come close to 3%.
At various points during the bull run since 2009, investors have been transfixed by this or that policy issue, whether it be the debt-ceiling impasse, the fiscal cliff, or the various QE programs the Fed has enacted. But for our money, it all comes down to earnings growth. From the 2009 lows to the present, recovery in the equity market (over 140%) fairly closely matches percentage growth in S&P 500 earnings from continuing operations (also around 140%) over that span.
Once again in 1Q13, core earnings were better than expected, reflecting the consistent "under-guide and over-deliver" policy of corporate CFOs. Earnings growth in the 4-5% range in 1Q13 was driven by modest revenue growth with some margin expansion, but also by non-operating events such as share buybacks.
We expect more stage-managed "surprise" EPS quarters, beginning with 2Q13. We think the buybacks will continue in 2Q13, although maybe at a somewhat slower pace because stock prices are higher. We also see growing dividends competing with buybacks and commanding a larger share of capital allocation. Within Equities, we particularly favor stocks with growing dividends.
As we move into the back half of 2013, EPS comparisons should become easier. The second half of 2012 was a period of policy-driven uncertainty around fiscal cliff. And then early in 4Q12, Super storm Sandy shut down big portions of the Northeast for a month or more. These factors prompted corporate decision-makers to move to the sidelines. If the global economy accelerates as comparisons become easier, earnings growth should improve. Altogether, we forecast earnings growing at a rate faster than 10% by 4Q13. And we are modeling additional earnings growth in 2014, supporting further equity appreciation.
Market Fundamentals: Technicals & Valuations
The bull market is probably in the second half of its life. For late-stage bulls, the key questions are: is everybody in the market already, and: should we be preparing for the end? Yes, stock prices are near all-time highs. And yes, it would it have been better to have bought stocks in 2009. While we don't have that opportunity any more, we do have an opportunity to buy a market that is priced at about 15-times forecast earnings, which is in-line with historical averages. Equally important, earnings are still growing, which will help keep valuations attractive even in a gently rising market.
Will still-attractive valuations and ongoing growth in earnings be enough to lure fence-sitting investors back into the market? AAII (American Association of Individual Investors) bullish sentiment data and ICI (Investment Company Institute) mutual fund flows data support the view that there is still retail or "individual investor" money on the sidelines. This trend is like an aircraft carrier - tough to turn, but once in place pretty steady. We think the aircraft carrier has begun turning.
While pure-play equity mutual funds are still showing weak inflows, the real action is in blended funds, which incorporate both stocks and bonds. Formerly strong flows into fixed income funds are being diverted into blended funds; while providing less of a clear signal, this does indicate more money moving into the equity market. The AAII bullish sentiment data is more mixed. In this weekly series, steady readings exceeding the 40% or 50% range would signal accelerating retail participation.
In addition to growing retail participation, the bull market requires continuing institutional participation. At Argus, we cover several of the big money managers. During their 1Q13 conference calls, this group sounded more excited than they had been in years. First there are these positive and growing net flows into equities. The IPO market has also come back to life. Yes, some of the deals are from private equity and yes, others are spin-offs. But the market's true function is to raise capital - and capital raising is always easier when investors are playing with the "house money" of a four-year bull market.
What about the technicals? Everyone watching the VIX has seen the gyrations in this indicator, but underneath the near-term turbulence is a more stable long-term trend. This sentiment indicator, which is now around 16, has bounced between 12 and 25 for the past year. While the current VIX is not far from all-time lows near 11, we think there's more to watch here than just the absolute number. In the past, we have seen the VIX stay tightly bound in a range of 12-18 for 3-4 years. This trend appears to be just beginning now.
In the year-to-date portion of this long-running bull rally, we have been impressed with sector breadth. For most of this year, all the sectors have been in the black; and six of 10 have generated double-digit gains. That is impressive, across-the-board breadth. As interest rates have headed higher, we have seen investors exiting the high-yielding telecommunications services and utility sectors while moving into year-to-date underperformers with a more risk-on flavor, including information technology, energy and materials. This rotation among equity sectors is healthy because it keeps the money in the stock market.
In setting our overall equity market targets, we always keep an eye on financial services. This was the sector that imploded in 2007-2009, taking the economy deep into the recession. As long as Financial Services remains a performance leader, the outlook for stocks should be positive.
Interest Rates & the Bond Market
Of course, underlying performance in financial services is linked to interest rates, which in turn is tied to the Federal Reserve and its interest rate policy. In just a month, the 10-year Treasury yield has spiked from 1.65% to 2.15%. At the low end of the curve, the Fed has not altered its excessively easy monetary policy. In fact, the Fed has not yet begun to "taper" its QE-based asset purchases, much less contemplate more restrictive monetary policy via a higher fed funds rate.
While we are generally favorable on equities as the most relatively attractive asset class, the inherent unpredictability in "tapering" is the main reason for our caution regarding the second half of 2013. Investors recognize that the Fed's two easing programs - quantitative and low rates - cannot go on forever. And Ben Bernanke will not be chairman forever. This creates two major points of uncertainty.
If Chairman Greenspan's legacy was slaying double-digit inflation, Chairman Bernanke's legacy may well be instilling a high degree of transparency into what had been a fairly opaque institution. For example, we know that the Fed won't be raising rates until unemployment touches 6.5% or inflation climbs above 2.5%. That's useful information in setting asset-allocation policy.
Once those inflection points approach or are in place, a whole host of questions will arise. What will be the pace of the Fed's unwinding? What will the slope of the yield curve look like? And what are the next signposts that might prefigure an actual hike in the Fed funds rate? We are hopeful that Chairman Bernanke further hones his reputation for transparency and starts to talk about "the other side" of the current easing program. With more information, investors are less likely to over-react and sell stocks at the first whiff of change. All asset classes would benefit from clear signs that the Fed has a plan to gradually remove itself from the market and then let the market function on its own.
The inherent unpredictability around "tapering" is a concern for equity investors. But our research suggests that stocks can hold up in periods of rising rates. Specifically, in periods in which the six-month change in bond yields has been greater than 20%, stocks have tended to appreciate, sometimes moderately and sometime vigorously.
Currently, we regard stocks - by our calculation, still about 15% below fair value - as the much better buy compared to bonds, which currently appear overvalued. Of course, low valuations don't ensure low volatility. Practically speaking, the calendar through the summer and the fall will be filled with earnings reports, and Fed speeches, releases of minutes, etc. We should expect volatility around each of these events.
But the fundamentals we have addressed - a strong economy, growing earnings, attractive valuations, okay technicals, and interest rates that remain low - support an extension in this now four-year-old equity rally. We would treat any dips, whether Fed-inspired or otherwise, as buying opportunities.