- The markets opened July – historically an uncertain market month – at full throttle and rallied into the July 4th holiday weekend.
- But the market has since grown uncertain, alternating up and down sessions as investors seek direction in a listless market environment.
- Earnings expectations are high, for once, and that could be a problem if results only match consensus.
Equity bulls have to like the generally parabolic stock chart for the year to date. After a very slow start to the year that carried through April, stocks in late May began to perk up. Stocks banked the bulk of first-half gains in the final week of May and across June. The markets opened July - historically an uncertain market month - at full throttle and rallied into the July 4th holiday weekend fired up by the strong June nonfarm payrolls report.
But accelerating gains also trigger bouts of profit-taking, as we saw on the first day back from the long holiday weekend. Market watchers have also been calling out some uncomfortable parallels with the summer of 2011, a season in which the S&P 500 crashed 17% and nearly ended the bull market. True, there is no debt-ceiling countdown this time. But with Speaker Boehner threatening to sue the President, the partisan gulf seems as wide and deep as ever. Geopolitical events have not dented the rally, but nothing has been "solved" either in Ukraine or in Iraq. Finally, record complacency in the market cries out for a correction, particularly given the dismal shape of the last GDP reading.
GDP, Interest Rates, and Earnings
The final report on 1Q14 GDP - down by 2.9 percentage points - was worse than the Street's worst expectations. In fact it was bad enough to prompt some investors to rethink the hypothesis that weakness in 1Q14 was a weather-related fluke, and in fact revealed some deep fissures in the economic recovery. But the numbers from spring and early summer argue that the economy continues to expand. The first-quarter pullback featured double-digit declines in domestic investment, spanning spending on residential and business construction, technology spending, and capital investment. The economy also experienced significant quarter-over-quarter contraction in private inventories, weak exports, and slack defense spending.
We look for gross domestic investment to rebound in 2Q14 and beyond, reflecting multiple positive data points recently in new home construction, industrial activity, factory and durable goods orders, and retail spending. Stability in Europe and recovery in emerging economies should be positive for net export activity. Given accelerating economic activity, we look for strengthening in private inventories. And we expect government to slowly move back into growth mode, after over three years of significant contraction at the local, state and federal level.
The chief driver in the domestic economy is the growing number of workers, as unemployment shrinks toward 6% or lower, and the ability of these workers to more fully participate in the economy. Altogether we are modeling GDP growth averaging 2.8%-2.9% over the next four quarters. We have learned the hard way that weather can be a significant economic disruptor and is in its own way a "Black Swan" event. That said, the underlying dynamics in the economy and increasing labor force participation argue for on-trend economic growth over the next 12 months or more. Our full-year 2014 GDP growth forecast is now under 1.5%, but we look for 3% recovery in 2015.
While GDP is in flux, interest rates are relatively stable. A year ago at this time, by contrast, the bond market was in headlong retreat. The 10-year Treasury note, which yielded 2.22% early in June 2013, plunged late in the month June, driving the long yield to 2.74% by early July. The five-year and 30-yields had similarly skyrocketed. Last year at this time, the market was just getting used to the idea that the Fed was really in the process of winding down its ultra-accommodative policy.
After the bond rally across the first quarter of 2014 and bond market stabilization in the second quarter, we are again seeing yields widen out - but in a much more controlled manner. The 10-year has moved up to 2.64%, but the change from 2.59% one month ago is not drastic. The five-year yield has made a relatively more dramatic move higher. The spread between the two-year note and the 10-year is 213 basis points, tighter than the 235-basis point spread prevailing one year ago.
The more measured pace of yield expansion may be consistent with a steadier and longer-term upward trend. Last year, the bond market moved so far and so fast that it ultimately overshot; the pendulum swing back to lower rates was almost a given. The current slower climb in yields is consistent with a moderately expanding economy, but also reflects chastened bond investors less willing to be burned by the kind of wild swing in rates we saw a year ago.
Our six-month rate outlook assumes rates will continue to work higher. We are modeling the five-year yield around 2%, the 10-year yield around 3.25%, and the 30-year yield above 4% in the coming six months.
We have now heard from the first reporters for 2Q14, led as always by Alcoa. Only five companies in the S&P 500 report results this week. The earnings trickle starts to flow by the middle of next week and will be a torrent later in July. After solid 6% earnings growth in 1Q14 for the S&P 500, we are modeling growth in the 8%-9% range for 2Q14. That is slightly higher than the 6.6% growth being modeled by Standard & Poor's, based on bottom-up assessment of analyst estimates.
Worth noting is that analysts, after several quarters of forecasting low single digit growth, are now more cautiously optimistic about the EPS outlook. That is a mixed blessing, in our view. With analysts routinely guiding for 1% or less growth in recent quarters, the market rallied on actual EPS growth in mid-single-digits. If earnings in 2Q14 do no better than current elevated expectations, we could see the market consolidate or even correct, particularly if guidance is typically cautious.
However, we remain constructive on EPS growth going forward. The Argus EPS forecast from Chief Investment Strategist Peter Canelo calls for EPS growth averaging 9.0% across the second through fourth quarters of 2014. Given the 6% start in 1Q14, we are modeling full-year 2014 EPS growth of 8.4%, which would be the strongest EPS growth since 2011.
For now, we are conservatively modeling 6% EPS growth for 2015, based on our expectations that higher fed funds and bank borrowing rates by mid-year will begin to crimp economic activity. However, again and again companies have demonstrated that their underlying earnings power is significantly stronger than the market has been modeling. Assuming the economic expansion has a few more years to go, we would anticipate raising our 2015 EPS forecast as 2014 unfolds.
Sector, Domestic and Foreign Market Performance
In the third week of May, what had been a sleepy year-to-date market began to accelerate. Stocks carried late-May strength into June. The performance in July has been scorching, with the S&P 500 already up about a point and half in the month to date. The strong June nonfarm payrolls number led a week-ending rally just ahead of the July 4th holiday, driving the monthly gain.
Looking at major domestic index performance for the year to date, we see continued leadership in value stocks. The Wilshire Large Cap Value index is leading year to date with 8.8% total return. Value has led growth for just over a year now, and currently holds a 380 bps advantage over Wilshire Large Cap Growth. Second place goes to the S&P 500, with total return of 8.5%. The Russell 2000 and the DJIA continue to track together in the low 4% range, an odd correlation for the small cap index and the bluest of blue chip indexes.
The Lehman bond index remains in positive territory, but gains have eroded in recent months. If the upswing in rates continues, we expect fixed income gains to continue to whittle away in coming months.
While the second quarter marked a general continuation of first-quarter trends, July has seen a significant shift in sector preference and performance, with investors swinging to risk-on and economically sensitive sectors and away from defensive investments. The best sector in 2Q14 was energy, followed by healthcare and utilities. At mid-year, the only sector down year to date was long-time market leader Consumer Discretionary.
In the short July trading month to date, however, Consumer Discretionary has come roaring back to market leadership. Utilities have backed down by over 400 basis, and are clinging to year-to-date leadership in the stock market by just a few basis points over both energy and healthcare. All three sectors are in the 13%-14% total return bracket. The only other sector with double-digit year-to-date total return is technology, at just under 11%.
Despite notable July strength, Consumer Discretionary remains at the bottom of the heap on a year-to-date basis. Industrials and Financials, both leadership sectors in 2013, are also bottom-five, along with Consumer Staples and Telecom Services.
We are not expecting a major change in pattern across the remainder of 2014. We do expect relative outperformance in economy-sensitive areas, particularly consumer discretionary, and a continued rotation away from income-sensitive areas such as Utilities and Telecom Services, assuming bond yields continue to rise.
The gradual move toward more cycle-sensitive equities is reshaping sector weightings. The most notable change on a month over month basis is in energy, which gained 50 basis points of sector weight last month as ISIL gained more ground in Northern and Western Iraq. Conditions in Iraq are far from stable. But as ISIL confronts more and more Shia-dominated territories, the pace of conquest has slowed. So too has the rate of change in energy prices, which are now holding just under the highs reached in the early days of this latest Iraqi crisis. As energy weighting increased last month, consumer and industrials sector weightings nudged lower.
On a year-over-year basis, economy-sensitive sectors continued to gain, including Technology (up 90 bps since July 2013), Industrials (up 50 bps), and materials (up 30 bps). In what we see as a secular rather than cyclical shift, and one driven by demographics and government policy, healthcare continues to expand. At a 13.3% weighting, Healthcare has now distanced itself from all the other mid-sized sectors. Consumer discretionary, at 11.8% weighing, is now 150 bps behind healthcare; consider that one year ago, Healthcare held a much slimmer 40 bps lead over Discretionary. To support this swing to cyclical and risk-on sectors, the sectors that have given up the most include Consumer Staples, down 90 bps in the past year to 9.5% at present; and telecom services, down 40 bps to 2.8% as more and more data travels over cable and via satellite.
Similar to what we said early in June, global markets are in better shape today than they were last month. The 11 indexes in our global survey are up about 6% year to date, after begin up about 4% year to date early in June and down about 1% in aggregate early in May.
The best performing global market remains India, up nearly 25% year to date on economic expansion and growth in the global information economy. Reflecting strength in natural resources demand and particularly energy products, Canada is in the number two spot with year to date capital appreciation topping 13%. Generally, mature markets are doing better than growth markets, but you could pretty much say that at any point in the past four years.
` Last year's leader Japan and embargo-beset Russia are the only major global indices in our tracker that are down year to date. In what has to be a positive indicator for global growth investors, the BRIC equity markets continue to recover. BRIC nations on average are up about 7% year to date, as India's outsized gain is balanced by Russia's negative return, which China and Brazil track in low- to mid-single-digits.
Stocks are off to a strong start in the second half, but as noted stronger up days may lead to more volatility and more corrective sessions. Lots could go wrong in the second half of 2014, including continued disappointing GDP growth, new global conflagrations, and the potential for a disappointing 2Q14 earnings season. Mainly, the market suffers from too much investor complacency, a condition that risks turning modest profit-taking bouts into full-fledged corrections. Yet for five years, the bull has treated all such obstacles on the wall of worry as stepping stones to new highs. We would remain invested and vigilant.