Policy giveth, and policy taketh away. The market rose across mid-September on the Larry Summers rejection and on the Fed standing pat on QE. But if you listened to Bernanke's comments, you realized that the primary reason the Fed held off on tapering was concern that the budget battle and the debt ceiling fight could cause a temporary government shut-down - which would further strain an already struggling economy.
On that basis, the market entered the trading week on tenterhooks. Despite bullish events in Europe (the Merkel win, positive PMIs) and China (the best manufacturing data in six months), stocks weakened out of the gate and only partly recouped their losses even amid positive corporate news (AAPL and BBRY).
The S&P 500 was not decimated on fear of a government shutdown; it merely weakened. The S&P 500 around 1,700 has slipped below its no-taper rally high of 1,730 from 9/18/13. Keep in mind that the index is miles away from setting a lower low; the 8/27/13 low was at 1,630.
But the index is at risk of once again slipping below trendline support. That support is still inverted; the 50-day SMA at 1,678 is above the 20-day trendline at 1,671. Recent weakness risks preventing the 20-day from crossing back up through the 50-day, as it has been on track to do.
Government-shutdown fears may be overblown. In July 2011, the GOP was feeling triumphant after wresting control of the House in the mid-terms elections. This time, the mid-terms are still to come; and the Republican core dreads risking the House majority for an unpopular shutdown. Unlike the cohesive and empowered Republican Party in mid-2011, Republicans this time are fractured and divided.
But the President too is weakened. With the President's popularity falling after the Syrian flip-flop, the GOP-controlled House is challenging the Democratic-controlled Senate. With Obamacare so divisive, we are not ruling out a shutdown.
The Economy, Rates, and Earnings
The second (preliminary) 2Q13 GDP reading showed 2.5% growth, representing a substantial upward revision from 1.7% in the Advance report. According to data from the Bureau of Economic Analysis, improvements in the private economy during the 2013 second quarter were enough to overcome the structural decline in government spending. Argus President John Eade noted that in 2Q13, government spending accounted for 17.4% of total gross domestic product, well below the historical contribution to spending of 19.6%. Personal consumption expenditures grew 1.8% in 2Q13, 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%.
Exports are also compensating for the weak government trend; exports were 12% of the domestic economy in 2Q13, compared with an historical contribution of 10.8%. Non-residential fixed investment, a proxy for corporate capital spending, rose 4.4% in 2Q13. We think these positives set the tone for a stronger second half, when we expect GDP growth to advance 2.8%. Given the net 1.8% GDP growth in the first half, however, our full year 2013 GDP outlook is in the low 2%-plus range. We continue to forecast 3% GDP growth for 2014. The economy will require a positive contribution from the government sector, in addition to continuing consumer and business spending growth, to reach 3% full-year GDP growth for 2014.
After the May-June lurch higher in interest rates, the long yield stabilized in July and August in the 2.6%-2.7% area. But midway through September, the 10-year yield is again knocking at the door of 3.0%. At the Federal Open Market Committee scheduled for September 17 and 18, the Fed is expected to specify the first reduction in open-ended quantitative easing since that program was initiated. Recent economic data such as August non-farm payrolls, while not necessarily robust, is consistent with economic expansion, and the Fed can no longer justify its excessively easy monetary policy. Accordingly, the yield on the benchmark 10-year Treasury bond has jumped to %, or nearly 30 basis points above where it was a month ago. Most elements of the yield curve are much higher than they were a year ago; the exception is the 3-month bill, which was actually higher a year ago. The five-year yield, at a current 1.75%, is at its highest level since July 2011 - and is actually higher than the 10-year yield from one year ago of 1.74%. The 30-year bond yield of 3.86% is 90 basis points above where it was a year ago. Treasury yields have risen quickly and in some cases are approaching our forecast yields for six months from now. We think a break above 3.0% in the 10-year bond would have psychologically important implications for bond traders, perhaps resulting in a structurally higher level of rates.
Just a few months after slightly reducing our profits outlook, we have raised our 2013 outlook for S&P 500 earnings from continuing operations to $111, from an earlier $110. Our EPS hike reflects several factors. We have switched our computation basis to Bloomberg data from Standard & Poor's data, given that Bloomberg has better alignment with actual historical earnings. Our profit hike follows yet another EPS outperformance in the second-quarter reporting period. In this era of tightly managed expectations, corporate CFOs tend to under-promise and over-deliver on earnings.
The biggest drivers of our EPS hike, however, are improvements in domestic and global economic activity. The Argus proprietary MUnCL model is pointing up, consistent with rising money supply, shrinking unemployment claims, firming commodity prices, and expanding business loan activity. In the U.S., the ISM manufacturing and services reports for July showed strengthening new order trends. Overseas, purchasing managers' indexes are improving in certain emerging markets and even in Europe. Finally, the dollar has pulled back from recent highs, benefiting the earnings of exporters and multinationals. Our outlook for 2014 S&P 500 earnings from continuing operations remains $121.50. Based on our use of Bloomberg data, the 2012 basis rises to $106; off that basis, we anticipate 5% EPS growth in 2013. But we look for stronger 9.5% growth in 2014.
Global Asset Markets
The S&P 500 has clawed back much of its 5% correction, and is doing so with economically sensitive sectors in the lead. From the late-August low of 1,630, the index reclaimed more than all its losses and is now consolidating in the 1,700 neighborhood.
Leadership has clearly changed hands. In the first quarter, when the broad market was rising by 10%, the three best sectors were Healthcare (up 15.5%), Staples (up 14.0%) and Utilities (up 12.4%). Healthcare has been a persistent theme this year as investors bet on positive implications from Obamacare. But Utilities and Staples moved to back of the pack in 2Q13. And in the third quarter to date (based on data gathered immediately before the "Summers End" rally, amid overall 5% index appreciation, Utilities (down 2.5%) and Staples (up 2.6%) are the bottom two performers. Financial Services, which has been having a strong year, is third from the bottom in 3Q.
At the top of the pile in 3Q13 is an unlikely leader, Materials, with 10.5% gain (SPDR performance data as of 9/23/13). Over the past year, investors became accustomed to headwinds from China's slowdown; but the data out of China and the emerging world began strengthening as summer progressed. In second place is another economic- and trade-sensitive sector, Industrials, up 10.0% in the quarter. Healthcare has done well in every quarter; tight behind it with 7%-8% gains are Technology, Energy, and Discretionary.
The trend change in leadership has had a meaningful impact on sector weights within the S&P 500. Despite a strong start to the year for high-yielding equities, the trend of rising bond yields has now cut into returns in those sectors where income is a meaningful component of total return. The weighting of the Utilities sector within the S&P 500 has fallen to 3.1%, down 40 basis points or 11.4% in the past 52-weeks. The most dramatic decline has been in the telecom sector, where market weight of 2.5%has fallen 80 basis points or 24%.
Even sectors in which income is a moderate return contributor, but which are seen as defensive in nature, have lost significant momentum. Compared with one year ago, consumer staples market weight has declined 70 basis points, to 10.2%. Meanwhile, weights for economy-sensitive sectors have expanded year over year, led by consumer discretionary and financial services. Even Technology has improved month over month, while remaining down year over year.
We recently conducted our quarterly analysis of sector weightings based on our six-input model. Based on that review, we raised our recommended weightings to overweight on Information Technology and on Healthcare, a sector that we not is not purely defensive. At the same time, we lowered our rating on financial service. Financial Service has moved to 16.7% weighting as of the end of August 2013, up nearly 200 basis points in the past year. The financial sector now appears fairly valued, thus warranting a recommended market weight. Altogether, we recommend overweighting Consumer Discretionary, Industrials, Healthcare, and Technology; market-weighting Consumer Staples, Financials, and Materials; and underweighting Utilities, Telecom Services, and Energy.
The major equity indexes in aggregate are doing better than they were a year ago by about 400 basis points. And after losing about 3% on average in August, the major equity indexes have spent September to date recouping their losses. Among the major indexes, and despite some sector realignment, we have not seen significant change in index leadership. On a style basis, leadership belongs to value stocks (25.5% 2013 total return) over growth stocks, by about 620 basis points. And in terms of size, the smaller-cap Russell 2000 (up 27.4% year to date) is more than 700 basis points ahead of the ultra blue chip Dow Jones Industrial Average. Meanwhile, the decline in the bond market has moderated. The Lehman Aggregate bond index, after being off 4.2% year to date early in September, is now down 2.5%. Still that is quite a turnaround from a year ago, when the Lehman index was up 3.4%. As tapering moves from theory to action, we expect bond losses to worsen.
The most significant month over month trend change among global equity markets has been the relative bounce-back in BRIC and resource-sensitive economies. The BRIC nations in aggregate are now approximately flat for 2013, after being down about 5% early in September and being down on average 8% early in August. The most dramatic turnarounds have been in those BRICs that are also resource-sensitive, namely Brazil and Russia. China and India, the other BRICs, are now averaging single-digit gains year to date, after being down an average 2%-3% YTD in August. Mature economies, including Japan and the U.S., surrendered some of their annual gains during August, but have since largely recouped those losses. Directly across the Atlantic Ocean, both UK and Europe improved fractionally on a month over month basis. While U.S. investors are not happy to see the S&P 500 surrender 3% in a month, the silver lining may be the long-depressed European economy showing signs of life. That should be a near-term positive for European stocks markets, as well as a long-term positive for U.S. multinationals.
The two strongest single-day sessions in the August-September timeframe came on news that Larry Summers would not stand for Fed Chairman, and on the Fed's decision not to taper in September. Policy is still a major market driver. Nonetheless, we are encouraged that the market has also shown a willingness to rise - albeit less dramatically - on positive economic data. Most of the incremental recovery off the late-August low has come quietly amid generally positive economic reports.
At the same time, the market's enthusiasm at the demise of a QE hawk and the huge cheer for the taper push-out signals that stock investors will not take kindly even to watered-down tapering. We maintain our view that amid the likely implementation of tapering, the stock market could end 2013 below its highs for the year.
(Jim Kelleher, CFA, Director of Research)