Remember all that partisan acrimony from early October? The market sure doesn't. A pair of data points - 2.8% GDP growth in 3Q13 and 204,000 jobs in October - acted like an eraser on the market's chalkboard memory.
The GDP report barely drew any notice. But the market response to the nonfarm payrolls number was very interesting. After Hampton Pearson told CNBC viewers of the huge beat relative to expectations (around 120K), you could watch index futures roll over from modestly positive in pre-market trading to deep declines just ahead of open. Once again, good news (jobs growth) was seen as bad news (policy acceleration in ending QE) for stock market and bond market players.
A funny thing happened by midday. Bonds continued to treat good news as bad news, as well they should. But stocks rallied by midday and carried accelerating upside into the close. Good news was again good news for stocks, as well it should be.
It's a long way from here in mid-November to the actual beginning of tapering, maybe in March or maybe in May. Along the way the Congress will approve (or block) Janet Yellen, and we'll get to see the ways in which she echoes and varies from Ben Bernanke. We could see a few more back-flips in which good news is bad news and bad news is good. Ultimately, we see underlying strength in jobs growth and GDP tipping the balance back to good news being good news for stocks. Since we see further acceleration in jobs and GDP in the months ahead, that is - well - good news.
The Economy, Interest Rates, and Earnings
GDP growth advanced a better than anticipated 2.8% in the third quarter of 2013, beating consensus expectations in the 2.3%-2.5% range. Although businesses and consumers were concerned about the possibility of government shutdown, which did in fact occur on the first day of the fourth quarter, people continued to "go about their business." Even within this higher-than-expected headline number, however, we saw cause for concern. The chief contributor to the above-consensus reading appeared to be real imports, which are subtractive to GDP; real imports increased just 1.9% in 3Q, vs. growth of 6.9% in 2Q13. But real exports, which are additive, also came down, to 4.5% in 3Q from 8.0% in 2Q13. Other growth components also reflected the overhang of the coming government shutdown. Real personal consumption expenditures increased a tame 1.5%, compared with 1.8% growth in 2Q13. Durable goods spending by consumers did tick higher, to 7.8% in 3Q from 6.2% in 2Q13. And the change in inventories added 0.83 percentage point to 3Q GDP after adding 0.41 percentage point to 2Q GDP.
Government remained a drag on spending in 3Q13, as federal GCE (government consumption expenditures) declined 1.7% in the third quarter after increasing 1.6% in 2Q13. Our model assumes that government will remain a drag on national GDP growth. We estimate that the private economy will continue to grow at a 3%-plus rate, overcoming this federal headwind. With sequestration continuing to chew away at government spending, the private economy will need to carry real strength into 2014. We believe it can, based on rising business investment, an improving job market, and more favorable net imports as domestic energy production continues to reduce reliance on overseas oil. Both manufacturing order and ISM service orders strengthened across the summer, achieving their best growth rates since recovery off recession lows in 2009. On the jobs front, nonfarm payrolls, the Household Survey, and the ADP report all suggest normal seasonal acceleration is taking hold this fall. Retail sales growth is steady, and Auto and home sales are percolating at high levels. Altogether, we believe the strengthening U.S. economy is poised for further acceleration in 2014
After the explosion in rates in the spring and the pullback in the summer, interest rates are again creeping higher amid signs that the economy continues to strengthen. Investors are also realizing that the tapering of quantitative easing, though pushed back from fall 2013, will likely begin sometime in late spring or early summer 2014. Treasury prices were hit hard in the first week of November following the much stronger than expected nonfarm payrolls report for October. In just the past week, the 10-year and 30-year yields each added more than 10 basis points.
The 10-year yield is not back to or even threatening the peak rate of 2.98% reached on September 5, 2013. Interest rates like equity indexes move in waves, and it is little surprise that the first try at 3% did not stick. But things could be different the second time around. We see a higher likelihood that once the 10-year breaches 3.0% for a second time, the yield will hold above that level. We see a higher likelihood that tapering will occur in 2014, once the transition from outgoing Fed chairman Ben Bernanke to income Fed chair Janet Yellen takes place. Given the fractiousness between Republicans and Democrats, there is a chance the Yellen transition could be blocked. But ultimately, we think a Yellen-led Fed will be unable to deny the reality that the recovering economy no longer needs the aid of quantitative easing.
On that basis, our six-month forecast for yields across the spectrum is above current levels. At the same time, we do not see yields running away. Inflation is low, running in the 1.2% range. The economy is better, but it is hardy over-heating. And the reality of tapering, rather than the perception, is likely to blunt the stock market and maybe even trigger a reversal. Altogether, our preliminary forecast is for steady upward movement in rates across 2014.
The third-quarter earnings season demonstrated that cautious company guidance disguises the aggregate earnings power of the S&P 500. With 3Q13 EPS season nearly over, Bloomberg data show that S&P 500 earnings have advanced 7% year over year, compared with the clueless pre-reporting consensus of 1% growth.
Because we do not drink the consensus Kool-Aid, for 3Q13 or for any quarter, our 2013 outlook for S&P 500 earnings from continuing operations is unchanged. The unfortunate reality of the government shutdown does add some uncertainty to the entire earnings year. Since the government got back in business, however, two reports have bolstered confidence in our slightly above consensus forecasts for this year and next. As discussed above, 3Q13 GDP growth of 2.8% despite government contractions demonstrates ongoing acceleration in the private economy. And the gain of more than 200,000 in October nonfarm payrolls suggests that jobs growth is overcoming headwinds ranging from bipartisan paralysis in Washington to uncertain growth in emerging economies to the Affordable Care Act.
Our outlook for 2013 earnings from continuing operations is $111 and assumes a 5% gain from 2012, with most of the gain back-weighted. We look for 4Q13 EPS growth to potentially reach double digits, as earnings benefit from easy comparisons against a year-earlier period disrupted by the Presidential election, Superstorm Sandy, and fear of the fiscal cliff.
Given that three-quarters of 2013 earnings have now been recorded, investors are increasingly focused on 2014 prospects. Our 2014 S&P 500 earnings forecast of $121.50 assumes stronger 9.5% growth in 2014. In order to reach our EPS target next year, emerging economies - source of 25% of S&P 500 earnings - must follow up their encouraging recent PMI reports with real growth momentum next year.
Sectors and Markets
As of mid November, the major U.S. indexes were up almost 400 basis points on average from where they were at the beginning of October. The market surge was of course fueled by the reopening of the government and avoidance of debt default. Forget the fact that these issues were not permanently resolved (the market already has) and that the two parties merely kicked the can further down the road.
While gains were recorded across the board, some investing styles did better than others in the past month. Value continued to widen its advantage over growth for the full year. The Russell 2000 underperformed the more Blue Chip indexes such as S&P 500 and even the DJIA.
A year ago, the spread between the top- and bottom-performing equity indexes was about 540 basis points, between DJIA (lowest) and Nasdaq (highest). This year, the spread is 690 basis points, between DJIA (lowest) and Russell 2000 (highest). But the spread this year "feels" tighter, simply because every major index is up over 20% year to date. Outside of equities, the Lehman bond index is negative, though slightly improved from a month ago.
Within the S&P 500, three sectors - healthcare, consumer discretionary, and industrials - have now delivered more than 30% total return for the year to date. Even lagging sectors, such as materials, utilities, and telecom, have averaged low-teens appreciation. And those three sectors are less than 10% of the market. For the 90%-plus of the market representing the other seven sectors, average year-to-date total return is a whopping 26.4%.
The outperformance in healthcare has a variety of contributors, including defensive (returning retail investors skew conservative), policy (ACA beneficiaries), and cycle (rising consumer healthcare usage). And discretionary is fueled by the twin engines of housing and automotive. Industrials is something of a surprise, as the dollar has been volatile and aerospace-defense has faced sequestration. The dollar has weakened since taper timing was pushed out to spring 2014 at the earliest; and defense-sensitive industrials have been planning for some form of government cuts for years.
In a sign of market balance, investors have been rotating to underperforming sectors that still have organic growth prospects. Staples was the best performer month over month, likely not because the economy is weakening - it is not - but because investors are looking for underappreciated values. Telecom services is also bouncing back from a year-long lag, which likely has less to do with performance than with fear of income sensitive equities.
Most sectors, like most equity indexes, are fairly tightly bunched and holding big gains. We believe bears will struggle to get their claws into this market, given how well-supported and broadly diversified the advance has become in the U.S. stock market.
Market sector distribution shows little change from early October. That is consistent with a market that has pushed to modest new highs with impressive breadth. The major event in the past month, which was the government shutdown, appears to have impacted market appetite and on that basis appears to be have affected all sectors about equally. But there are a few changes at the margin.
On a month over month basis, four sectors - technology, energy, utilities, and materials - did not change their weightings at all. Financial services edged 20 basis points lower, perhaps in response to underwhelming earnings from the big banks. Consumer discretionary also gave back 20 basis points as investors banked profits in this highly appreciated sector. On the other side of the ledger, staples added 30 basis points month over month, as investors positioned defensively during the most acrimonious phase of the shutdown.
On a year over year basis, most of the trends we have seen in past months are still in place. The Technology sector is about 120 basis points smaller in market weight than it was a year ago, as disruptive technologies including cloud, analytics, big data, and everything-as-a-service have confused and delayed IT spending decisions. Consumer discretionary is 110 basis points bigger than it was a year ago, as increasing consumer employment and confidence have contributed to higher basics and big-ticket spending. Energy is smaller in sector weight, even as domestic energy infrastructure continues to grow. And industrial is bigger, as investors bet that the two-year doldrums in China and the emerging world is about to end.
Healthcare is one of several highly appreciated sectors that is higher year over year but lower month over month. With three sectors (healthcare, discretionary, and industrials) up more than 30% year to date, we would not be surprised to see investors realizing profits in these areas.
In terms of global equity market performance, as the year winds down three themes seem to stand out.
Leadership is firmly in the mature economies. Japan, the U.S., the U.K., and the eurozone in descending order represent the market leaders among the 10 or so global markets that we track. Japan had its once-in-a-lifetime Abenomics, featuring huge QE and subsequent (and deliberate) currency collapse. The U.K. and Europe are showing discipline on austerity and monetary policy. And the U.S. is in the midst of a very strong consumer-led recovery.
The resource economies are better than they were a few months ago, but ultimately not much better. The much anticipated revving-up of the Chinese economy somehow has not gotten underway; the starter keeps turning over, but the engine wont' fire. That said, we look for a structurally "cleaned up" China to drive a resource-economy recovery in 2014.
At the back of the parade are the emerging economies, with BRIC nations at the very back. Corruption in India, inflation in Brazil and government tinkering in China equate to another year of lousy BRIC market performance. We won't forecast recovery in the BRICs in 2014. If enough investors swing to that way of thinking, BRICs have a better chance of leading global market performance next year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.