- Given the carnage in former high-flyers, it is easy to see what investors don't like, and harder to determine what they do like.
- Instead of seeing this as a stock-picker's market, we are staring to see it as a theme-picker's market.
- Similar to year-to-date domestic equity index performance and sector performance, it is difficult to discern a clear pattern in foreign equity market performance.
Welcome to the Icarus market. Stocks that formerly performed loop-de-loops around the sun are melting in the heat and crashing to earth. High-flyers such as Tesla (NASDAQ:TSLA) and Netflix (NASDAQ:NFLX), but also proven growth names such as Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN), have fallen from favor.
While it's easy to see what investors don't like, it is a bit harder to see what they do like. Some overbought sectors and markets have come back…but others haven't. Some former in-favor sectors have sold off, but others haven't.
Is this a stock-picker's market? Maybe it's a theme-picker's market. For instance, the semiconductor universe within Argus coverage is up 8.0% year to date. But our computing group is up just 0.3%. While the cloud is doing away with on-premises hardware (bad for equipment companies), even data farms filled with white-box servers need silicon inside (good for semiconductors). As long as the market continues to churn, we would expect to see similar theme-driven investing in 2014.
Stocks could still catch a bid, of course. The tone of domestic economic data has been fairly good, with non-farm payrolls showing normal end-of-winter strength. Still, last year's 30% gain has left investors skeptical about near-term market prospects. Strong second-quarter stock gains may require incredibly good domestic economic data and a clearing-away of global uncertainty in China and the Ukraine. Until then, expect more of the same.
The Economy, Interest Rates and Earnings
At the end of March the U.S. Bureau of Economic Analysis offered its final take on 4Q13 GDP. The economy grew at a 2.6% rate in 2013's final quarter, up from a previously reported 2.4%. Positives in 4Q13 included 3.3% growth in personal consumption expenditures, up from 2.0% in the third quarter and a sign of growing consumer participation in the economy. While the PCE number may have received a bump from Obamacare enrollment, consumer trends were broadly strong. Non-residential fixed investment, a proxy for corporate spending, grew at a healthy 5.7% pace, IT equipment spending grew in low double digits, and exports rose 9.5%. On the downside, spending on residences declined nearly 8%, and federal spending continued its multi-year decline, while state and local spending was flat. While the most vigorous phase of the housing recovery may be behind us, we expect a more restrained housing cycle to resume with the onset of warm weather.
We have shaved 20 basis points off our full-year 2014 GDP forecast, bringing it to 2.8% from a prior 3.0%. The severe weather across the January-March period cut into first-quarter activity, particularly in consumer spending and the housing market. We also sensed some exhaustion in these formerly fast-growing areas. That said, and the weather-impacted first quarter notwithstanding, the positive trends in consumer spending, exports and non-residential fixed investment and IT spending should support GDP growth in the 2.5%-3.5% range for the next several quarters.
Looking ahead to 2015, Argus is modeling 3.1% GDP growth in our initial forecast for next year. We look for a strong start to 2015 as the economy should be firing on all gears but without the restrictive impact of higher short-term rates. Beginning in mid-2015, we look for the Federal Reserve to begin boosting the Fed funds rate at a measured pace. We are therefore modeling slightly faster GDP growth in the first half of 2015 than in the second half. Government spending may be at an inflection point. Looking ahead, we expect the declines in federal spending to narrow in 2014, and believe both federal and state and local spending could be contributive to GDP in 2015.
A year ago, U.S. interest rates were sliding lower despite growth in the global economy. We did not know it at the time, but the 10-year yield was preparing to put in a bottom at 1.6% in May 2013. By year-end 2013, with the long yield at 3.0%, it seemed clear that the trajectory of rates was higher. But the bond market has been extremely choppy this year. Despite the steady tapering in QE and guidance from Fed Chairperson Yellen that the Fed could begin hiking rates in mid-2015, long yields are 30 basis points lower at present than they were at year-end 2013.
All eyes are generally on the benchmark 10-year note and on the very short end, which is sensitive to the Fed funds rate. Quietly, the middle of the curve has resumed its upswing. Compared with one month ago, two-year and five-year yields are higher by about five basis points. Conversely, the 10-year yield has come down from a month ago, while the 30-year yield dropped 15 basis points relative to a month ago. This may reflect increasing slack in the housing economy after a harsh winter.
Year-to-date performance in the bond market has been a slight surprise. But a look at year-ago rates reminds us that the bond market has undergone a major trend change in the past 12 months. While long rates are not where we thought they would be by now, we note that the yield curve remains steep, meaning bond investors continue to anticipate an expanding economy. Our outlook for the short-end of the curve is unchanged. We do not expect the Fed to begin hiking rates before mid-2015. Elsewhere along the curve, we would expect a gradual rise in rates across 2014 consistent with a slowly expanding economy.
First-quarter earnings season is just getting underway although most companies won't report until after April 20. For the S&P 500, one month ago we reduced our outlook for 1Q14 earnings to $28.35 per share, from an earlier estimate of $29.75. Our revised 1Q14 estimate assumes 6.2% growth.
More and more companies provide explicit EPS guidance. The consensus of analysts almost unfailingly arrives at the guidance midpoint, and companies providing guidance are inherently and understandably cautious. That's a formula for the Street to underestimate earnings, and that is what has happened across most quarters during this bull market.
For once, though, we see risks that earnings could lag rather than exceed our expectations. Of course investors have discounted the impacts of the severe weather across the country. But the weakness in housing and durables spending in recent months is likely more than weather-impacted. Spending on vehicles has surged in recent years, while the housing recovery is already a few years old. We think there is an exhaustion component along with the weather component impacting first half 2014 economic activity.
However, we view the mid-winter slowdown as a pause rather than as the beginning of a reversal in trend. Housing is still well below its historical contribution to GDP. And job growth appears to be accelerating, with growth in March non-farm payrolls coming in higher than the three-month and six-month averages.
Earlier this year, Argus Chief Investment Strategist Peter Canelo introduced his preliminary EPS forecast for 2015. Off the estimated 2014 base, Peter is modeling 6% growth in continuing operations earnings, to $127.25, for 2015. At present, our 2015 estimate is well below consensus, which is in the $130-$137 range. In our view, as the Fed begins to raise interest rates, economic activity could be impacted by the rising cost of doing business. We will therefore be slow to hike our 2015 EPS estimate, unless actual 2014 earnings blow expectations out of the water.
Sectors And Domestic and Global Markets
The following observations are based on end-of-first quarter closing prices. In the subsequent period, domestic and global markets have continued to churn amid signs that the early downtrend in 2Q14 may be abating.
After hitting bottom on February 3 and rallying into mid-March, most major domestic indexes slumped sharply in the final two weeks of March. As geo-political worries intensified and growth economies such as China remained stalled, the market showed an increasingly risk-off tone as March wound down. Relative to the prior month, the worst-performing indices were weighted with small caps (Nasdaq Composite and Russell 2000) or sensitive to global growth (Wilshire Large-Cap Growth). Wilshire Large-Cap Value was the best relative and absolute performer, actually gaining 60 bps of capital appreciation last month. The Dow Jones Industrial Average held about steady.
The Lehman U.S. Aggregate Bond Index is now tied with the S&P 500 for domestic index performance with about a 2% gain. In fact bonds are doing relatively better in 2014 than they were doing this time last year, when the Lehman index was barely above break-even. In the second quarter to date, U.S. Treasuries have continued to strengthen while equities are in broad decline. Unless we have really misjudged the economy and corporate earnings prospects, we would expect the equity indexes to outperform bonds going forward from here.
The most significant trend change in the equity market year-to-date has not been about relative sector performance, or about style swings from growth to value or size swings to large-cap from small cap. The biggest change has been in investor attitudes toward momentum, which is suddenly a dirty word.
So here comes the anti-momentum sector, utilities - the surprising year-to-date winner and the only double-digit gainer so far. Investors are reflexively surprised whenever utilities lead over bigger sectors. After all, it is slow-growing (less than half the rate of S&P 500 earnings growth) and little (just 3% of S&P 500 market weight). But given the reversal in long yields, income stocks have swung back into vogue. The market is also more defensive now than it was in 2013, further favoring yield. And finally, that harsh winter we just survived will likely drive above-estimate EPS growth for the utility companies.
The hardest-hit momentum sub-sector has been biotech, and that is impacting both sector weight and performance in the healthcare sector. The most durable sector leader during the five-year bull-market, healthcare slipped to 13.4% of S&P 500 sector weight as of the end of March, compared with a multi-year high of 13.7% as of the end of February. March 31 marked the official end for the enrollment period in the health exchanges under the Affordable Care Act. With that deadline having passed, many investors are casting around for new focus sectors.
The chief beneficiary of dis-investment in healthcare, somewhat surprisingly, has been financial services, which picked up 50 bps of weight in the past month. Leadership has not come from the big banks, but rather from regional and diversified banks, consumer finance, and P&C insurers.
Several sectors were up 2%-3% year-to-date as of the 1Q14 close. These include technology, financials and materials. Energy is not in that group, but has lately shown momentum. All of these sectors are sensitive to the economic cycle.
In a further sign that no clear trend is in place, the two consumer sectors - one defensive, one cycle-sensitive - continue to lag. Consumer Staples has been a chronic underperformer for most of the bull market, resulting in a multi-year low 9.7% sector weight in February. Staples had a light mean reversion bounce in March, but remains below 10% of S&P 500 sector weight. Consumer Discretionary continued its year-to-date fall from grace, declining to 12.5% of S&P 500 weighting as of the end of March compared with 12.9% as of the end of February. The performance of Consumer Discretionary is at odds with a consumer economy that appears to be shaking off the winter cold.
Our survey of 11 global markets was down an average 4.3% at the end of March, rebounding off the 7.2% decline as of the end of February and about level with the 5.0% decline at the end of January. While there has not been a huge trend change in global stock markets, there have been a few tweaks in leadership. The biggest bounce-back comes from a pair of BRICs, India and Brazil. India is now up nearly 6% year to date, while Brazil has reduced a 10% loss one month prior to a 2% year-to-date loss as of March-end. While Russia continues to lag, the Russian market has recovered from its lows immediately after the Crimean incursion.
Among mature economy markets, Canada leads with a 6% gain. Canada is in our hard-currency group and thus is forecast to outperform. The Eurozone and U.S. are up about 2% year to date. Among our good trading partners besides Canada, Mexico and China are both down about 6% year to date. Similar to year-to-date domestic equity index performance and sector performance, it is difficult to discern a clear pattern in foreign equity market performance.
Jim Kelleher, CFA, Argus Director of Research.