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Summary

  • Investor sentiment moved to very bearish in May, driven by geopolitics. Investors reduced risk, and now have to get back in.
  • Economic data were very strong in May, including employment (jobless claims and payrolls), housing, consumption, etc.
  • U.S. equities broke out on the upside in 2nd half of May, with all major indices reaching all-time highs.
  • The tectonic sentiment shift from negative back to positive is starting, and will support the strong equity rally.

Here we are in the middle of 2014, and many investors/advisors are reassessing their asset allocation for the rest of this year. Investors and managers who actively manage their asset allocation to position it according to near-term risk-return expectations may find this update useful. After all, research done since 1986 has shown that in a diversified balanced portfolio, 90% of return and risk comes from asset allocation1.

Negative Sentiment

Just as soon as concerns about Fed's tapering of stimulus dissipated, a new wave of nervousness rose among individual investors and managers alike in April-May. This was created by intense media coverage of geopolitical crisis in Ukraine, U.S. sanctions on Russia, and pronouncements of the "new cold war." Concerns about a potential credit bubble in China only helped fuel fear. And of course, above-average valuation metrics continue to concern value-minded investors. As a result, the prevailing opinion here at Seeking Alpha, for example, is almost universally bearish, with numerous authors expecting a market correction in 2014 (after doing so in 2013 which didn't happen) and advocating a bearish/defensive positioning.

Professional investment managers were not immune to the negativity and reduced risk significantly in May, according to the BofA Merrill Lynch Fund Manager Survey, with the largest group of respondents (36%) citing geopolitical crisis as the reason, and another third citing debt problems in China. Cash levels have reached 5% of portfolios - the highest level since June 2012. A net 22% of managers were taking below-normal levels of risk, up from 11% a month ago, and the proportion of asset allocators overweight equities has fallen to a net of 37% from 45%.

Despite all this negativity, equities have continued grinding higher this year. Why? It is the fundamentals that matter for markets, not sentiment, and U.S. fundamental economic data have been strong, and are getting stronger.

Performance of Major U.S. Markets since Apr. 30, 2014

Source: Ycharts

It's the Economy!

I would like to cite just two areas of economic strength: employment and housing. Employment remained the "last bastion" - the area of the U.S. economy that could be credibly cited as evidence of weakness by pessimistic economists - but only until April. Initial Jobless Claims dropped to the closely-watched 300,000 level in May, which is the lowest level since 2007, before the Great Recession. This moved the less-volatile 4-week moving average of claims to 310,000 (see chart).

Payroll numbers have also been very strong, including 217,000 jobs added in May that pushed payrolls past their pre-recession peak. May also marked the fourth straight month payrolls have increased at least 200,000. Bloomberg reported annual average of monthly payroll of 214,000 YTD, the strongest since 1999 on that basis (see chart).

As part of our analysis, we find that housing market factors are very significant drivers of U.S. equity market returns, even in near-term (3-6 months). Home sales, which had stabilized in winter, are now rebounding, aided by stable-to-lower mortgage rates. The House Price Index continued to rise this year without even a pause (see chart), while Housing Starts rebounded strongly from winter freeze to about 1 million units at annual rate.

Strength is not limited to these two sectors; it is evident in most areas of economic activity: consumer spending, confidence, durable goods, etc. On the other hand, many investors and managers were influenced by geopolitics and reduced their portfolio risk. "The band was stretched" - those folks now have to get back in, which will bid up equity prices. So, it was not all that surprising to see the equities break out on the upside in the second half of May, with all major indices reaching all-time highs. The S&P 500 (NYSEARCA:SPY) broke above the psychologically-important 1900 level (see first chart). Growth equities (IWF, IVW, VUG, RPG) are in the lead once again (+6.7% for RPG since Apr 30), as they typically are during strong bull markets. Gold (NYSEARCA:GLD) dropped, also unsurprising in an environment of rising spirits.

How strong will the rally be? The tectonic sentiment shift from negative back to positive that is now starting, and the likely spread of economic strength from employment to incomes, make me think that it will be quite strong - our latest forecast for the S&P 500 six-month return is between 5% and 10%.

What about valuation?

There is no denying that equities are somewhat expensive. The P/E ratio for the S&P 500 is above average at 17.6 on the trailing 12-month basis (see chart). However, the P/E ratio alone does not predict well equity returns in the near term (say, over 6-12 months) - a mistake that many authors make. If we are considering our tactical asset allocation for the rest of this year (the purpose of this article), the P/E ratio is not a very useful indicator. In addition, high absolute P/E is not as high on a relative basis, compared to bonds, due to very low interest rates.

(click to enlarge)

There is more to valuation than that, which I will try to describe in more detail in an upcoming article.

Tactical Portfolio Ideas

I list below several strategies/ideas for investors who take a tactical approach. In the upcoming bull market that I expect:

  • We recommend (and do in tactical portfolios that we manage) to shift balanced portfolios from bonds (IEF, LQD) to equities as much as you are comfortable with (or as much as client policy allows).

Within equities:

  • I think that Value will underperform - we prefer broad market (SPY, IVV) to value (IVE, IWD). Avoid defensive sectors such as utilities (NYSEARCA:XLU).
  • Growth should outperform the broad/balanced market - ETFs such as (IWF, IVW, VUG) should do well. Broad Tech sector (QQQ, XLK) likely do well (but I would avoid Social Media - that mini-bubble will not re-inflate).
  • I think that small-cap (IWM, IJR, VB) selloff is over and they may bounce in short-term, but we don't see them outperforming over 3-6 months.

[1] See, for example, Brinson, Hood and Beebower "Determinants of Portfolio Performance." Financial Analyst Journal, 1986.

Disclosure: I am long SPY, RPG. 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.

Source: Equity Rally Is Just Getting Started