The ink was barely dry on our thesis that the market was ready to rally on good economic news, rather than policy news, when stocks shot higher on what was unequivocally a QE-related event. On 9/15/13, former Treasury Secretary Larry Summers withdrew his name from consideration to become the next Chairman of the Federal Reserve, a post currently occupied by Ben Bernanke. Summers is regarded as a policy hawk who does not like QE and would have been likely, in the Fed post, to move to eliminate it quickly. In the bid to become the next Fed Chairman, Summers was seen as holding a slight lead over former Fed governor and policy dove Janet Yellen, who favors very gradual QE wind-down.
Though formerly favored by the President, Summers faced multiple challenges to winning Congressional approval. Summers' letter withdrawing his candidacy hinted at the acrimonious hearings his nomination was likely to trigger. Summers simply did not have a broad base of support, even in the President's party. On the right, Republicans were set to fight his nomination. On the left, hardline Democrats disliked Summers because he supported deregulation while serving as Bill Clinton's Treasury Secretary.
Congressional rejection of Summers would have represented another failed initiative for a President whose political capital was reduced by the Syria flip-flop. As the President prepares for the October 1 implementation of Obamacare and girds for the debt-ceiling extension battle, he could not afford to give the Republican House another victory.
We are not withdrawing our thesis that the market is ready to rally on and align with a rising economy. But the "Summers' End" rally is a reminder that the equity rally has a QE component. And it reinforces our view that while 2013 will likely register as a strong year for the stock market, the year may not end with the market at peak prices.
The Summers withdrawal now changes the QE calculus; the range of possibilities in the QE wind-down process has likely changed. Before, we viewed the possible wind-down scenarios as ranging from gradual to accelerated. We now see the wind-down scenarios as ranging from gradual to less-gradual.
A Season of Discontent
Investors, like every one else, respond to loss in stages. Beginning in April, when the Federal Reserve first began acknowledging the potential end of quantitative easing, investors responded to QE's pending demise first with shock; then with denial; next with grief; and finally with acceptance. At the recent G20 meeting in Russia, and even amid the heated debate on Syria, global economists grappled not with the wisdom of winding down QE, but rather how this process would unfold.
The end of QE, in other words, has moved from the unthinkable to the widely anticipated. As that has happened, investors are showing willingness to treat good economic news as good news for stocks. That was not the case in late spring through early summer - the shock and denial period - when every QE rumor sent stocks lower. After a modest July bounce, stocks entered their grieving period in August, as the S&P 500 fell 3%. As September proceeds, the stock market is steadying if not quite rallying, in a sign that investors have accepted the inevitable.
A small segment of the investing community argues that all or nearly all of the market recovery since the recession is a smoke-and-mirrors job built on quantitative easing, and that the market will tank once QE is pulled away. It is difficult to square that belief with the reality on the ground. Either you concede that the multi-year bull rally has correlated with a solid recovery in global economic fundamentals and corporate profits; or you attribute a doubling in corporate profits since 2008 purely to the Fed's monetary policy. If you choose the latter argument, you are implicitly suggesting that the Federal Reserve has become most successful corporate profits generator in the history of finance.
Most mainstream investors acknowledge that QE, even if not the primary driver of the market recovery off its lows, has at least played a role in the corporate profit recovery that has fed that stock rally. Principally, global QE has held down interest rates worldwide even amid global economic recovery. The reduction in debt service has helped expand net profit margins. Borrowing costs for S&P 500 companies represented just 1.4% of revenue in the past 12 months - the lowest level that Bloomberg has recorded in its 11 years of compiling this statistic.
As the demise of QE becomes less of a shock and more of an accepted element in the investing environment, investors are beginning to bid stocks higher in the wake of positive economic news. So far, investors' enthusiasm has been tempered; very strong data points are begetting fairly weak rallies. Don't forget that the market has had to deal with the four stages of QE loss across what is historically its weakest period of summer.
Better Autumn Ahead?
In spite of these challenges, the equity outlook is improving for a variety of reasons. One, the calendar is with the bulls. The June-September period represents by far the weakest four-month span in the investing year (based on our analysis of S&P 500 monthly performance dating back to 1980). The final three months of the year, by contrast, represent the best time to be in stocks.
Second, after a wobbly June-July period, the market corrected meaningfully in August 2013. The 4.7% pullback in the S&P 500, from 1,709 on 8/2/13 to 1,630 on 8/27/13, has had the usual salutary effects. These include more sharply shaking out the unworthy "coattail riders" on the rally, creating more attractive entry or dollar-average points for those in the market, and piquing the interest of sideline sitters who had heretofore regarded the market as too expensive.
Third and most important, the global economy appears to be revving up, setting the stage for further corporate profit growth and stock appreciation. The stock market's willingness to rally on good news would be moot if there were no good news on which to rally.
The most encouraging recent data point, because it is the broadest economic measure, is GDP. Preliminary GDP growth was revised up to a 2.5% growth rate for Q2 2013, from an advance 1.7% reading. Improvements in the private economy were enough to overcome the structural decline in government's contribution to the economy. According to Argus President John Eade, Government spending accounted for 17.4% of total gross domestic product in Q2 2013, well below the historical contribution to spending of 19.6%. Personal consumption expenditures grew 1.8% in Q2 2013, led by 3.2% growth in goods - including 6.2% growth in durable goods. During the second quarter, consumer spending amounted to 68.6% of the U.S. domestic economy, better than its historical contribution of 67.5%. Non-residential fixed investment, a proxy for corporate capital spending, rose 4.4% in Q2 2013.
Recent domestic data is even more positive than the second-quarter GDP reading. Internet sales, automotive unit sales and housing represent three very strong consumer economy drivers. Auto sales approached 16 million SAAR in August, the highest level since 2007. Existing home sales in July were at the highest level since 2007. Even though forced sales are dwindling, total home sales have advanced 17.2% over the past 12 months.
The jobs data signals gradual but ongoing recovery in the U.S. labor market, in turn fueling consumer purchases. Rather than focus on single monthly data points, we focus on the trend in unemployment insurance (UI) claims. On 9/5/13, the Labor Department reported that UI claims in the final week of August dropped to 323,000, the lowest reading since June 2008. The four-month rolling average of 328,500 was at the lowest level since October 2007.
Argus Chief Investment Strategist Peter Canelo notes that the ISM's manufacturing and non-manufacturing New Order indexes were up sharply in July and August. According to ISM, Manufacturing New Orders rose 14.4 points in the past three months, the strongest pace since the recovery really got going in spring 2009.
The S&P 500 component companies are global in nature, so domestic data alone will not drive profit growth. Chief Investment Strategist Canelo points out that both manufacturing and services PMIs (purchasing managers' indexes) have strengthened this summer across Europe; PMIs are finally improving in Asia as well.
Given this improving economic backdrop, and reflecting inputs to our six-point sector model, we have made several changes in our recommended sector weightings. We now recommend overweighting the Information Technology and Healthcare sectors; previously, these sectors were recommended at market weight. We are reducing the Financial Services sector to recommended market weight from a prior recommended overweight. We would now mimic market weight in financial service companies, following an increase in the financial services' sector weighting to 16.4% at present from the 14% range one year ago.
Our recommended sector weightings are as follows:
· Overweight: Consumer Discretionary, Healthcare, Technology, and Industrials,
· Market Weight: Consumer Staples, Financial Services, and Materials
· Underweight: Energy, Telecom Services, and Utilities