Risks Rising With Evidence Now Neutral
We have downgraded our view on Fed Policy to neutral and that leaves the overall weight of the evidence neutral. This marked deterioration in the weight of the evidence (coming into 2015 the weight of the evidence was a +2/bullish) suggests that the risk of correction has increased. A breakdown in broad market trends could signal that such a risk is being realized. The more cautious view on Fed Policy is not a suggestion that the Fed is poised to aggressively raise interest rates. Rather, our view on rates is little changed. While the Fed may be looking for an opportunity to raise rates (September now seems like the earliest they could move), we are not sure that the incoming economic data or the global macro backdrop will support such a move. With downward pressure on inflation being seen around the world, the argument for pre-emptive action from the Fed is weakened. In the face of this trend, the trade-off between inflation and employment may become untethered for a time. This removes a major argument for raising interest rates. Without evidence of an uptick in inflation, the best course for the Fed may be to bide its time. This data dependency can be misinterpreted by the market, and attempts by the Fed to better clarify its position, while also retaining necessary policy flexibility, has ironically added to near-term stock market volatility. We do not expect this to change in the near term.
The Federal Reserve’s dot plot shows that most members of the FOMC (as of March) expected interest rate hikes in 2015. We have been skeptical that the Fed would have both the opportunity and the need to raise interest rates this year. In an attempt to transparently convey its view that it is taking a data-dependent approach, rather than pursuing a pre-set path, the Fed may be introducing additional volatility into the financial markets as every data point gets analyzed both on its own merit and how it compares to expectations.
The Federal Reserve is governed by a dual mandate: price stability and full employment. Traditional economics teaches that there is, in the long run, a trade-off between inflation and employment. The Fed’s job is the balance these trade-offs in real-time. One argument for raising interest rates sooner rather than later has been to prevent an unwelcome rise in inflation. Right now, there is little evidence that inflation pressures are building. In a persistently low-inflation environment, the Fed may be able to be more patient than is currently acknowledged.
The trade-off between inflation and employment is typically viewed through the lens of the unemployment rate. The idea is that the unemployment rate can fall only so far before inflation pressures build. But if inflation is persistently low for other reasons, the “full employment” unemployment rate may be lower than currently acknowledged. In other words, the unemployment rate could fall further before stoking inflation pressure. This further diminishes the need for pre-emptive action by the Federal Reserve.
Economic growth overall clearly cooled in the first quarter of 2015, although year-over-year measures of activity stayed elevated as the first quarter of 2014 was also a weak spot for the economy. But looked at from a longer-term perspective, favorable growth trends in the economy remain intact. Real final demand (which removes from the GDP data the distortions in trade caused by currency and global macro headwinds) continues to show evidence of moving into a higher gear. Real disposable income surged more than 6% (annualized) in the first quarter. While not as robust as some had hoped, the economic fundamentals continue to show gradual improvement and are supportive of higher stock prices.
Valuations remain a concern at current levels, not because they argue for immediate weakness in stocks, but because history suggests current valuation levels are consistent with subpar returns going forward. It is important to remember that valuations can change based on movements in two variables: price and earnings. In the current environment, improving growth trends could lead to improved earnings and/or a near-term price correction could relieve some of the current valuation excesses.
Investor sentiment remains problematic. The indicator shown here (the NAAIM Exposure Index) reveals an elevated level of equity exposure among active investment managers. This is echoed by the latest advisory service sentiment data the shows bulls at 57% and bears below 14%. Readings where bulls exceed bears by more than 40% have historically argued for caution. When the crowd is pretty unanimous in looking for higher stock prices and complacency is widespread, the stock market tends to surprise investors by moving in the opposite direction.
The cycle composite for 2105 shows a strong upward bias for stocks over the course of the year, but so far, that has not really played out. Now both the four year presidential cycle and the one-year seasonal cycle are on the cusp of becoming more cautious (Sell in May and Go away). Even beyond the seasonal patterns, the price trends have already cooled as upside momentum has been largely nonexistent this year. Lurking in the background is the negative influence from the January barometer this year, which could offset the historical tendency of years ending in “5” to show robust returns (20% on average over the past century).
Breadth remains bullish. Given the deterioration seen in other indicators, this is an increasingly important support for the stock market. The concern is that while the cumulative advance/decline line has moved to new highs, the actual performance of the average stock has been more lackluster. The percentage of stocks in the S&P 500 trading above their 50-day averages has broken down this month, a sign that broad market strength may be fraying. We will continue to watch breadth indicators closely as further deterioration could push the overall weight of the evidence into negative territory.
We have been watching the improved performance of small-caps relative to large-caps over the past six months, but that up-trend is now faltering. Recent relative weakness in small-caps has pushed this ratio below important trendline support. It is too early to conclude that this trend has run its course, but momentum has certainly waned and seasonal headwinds for small-caps will soon begin to blow. If small-caps are going to retain a leadership position, this ratio should soon stabilize and a new, perhaps more moderate, uptrend could emerge.
From a sector perspective, leadership remains with Health Care and Consumer Discretionary. Those sectors show the best absolute and relative price trends. They also show broad participation at the sub-industry level. While relative strength is typically thought of as leadership in periods of overall market gains, it also manifests itself as relative stability in periods of overall market volatility. Staying with the leadership group as it reveals itself rather than going strictly based on historical sector rotation patterns may be a better approach to risk management in the current environment. Typically defensive yield plays look like crowded trades right here.
BAIRD STRATEGIC ASSET ALLOCATION MODEL PORTFOLIOS
Baird offers six strategic asset allocation model portfolios for consideration (see table below), four of which have a mix of equity and fixed income. An individual’s personal situation, preferences and objectives may suggest an allocation more suitable than those shown below. Please consult a Baird Financial Advisor in determining an asset allocation that will meet your needs.
Baird’s Investment Policy Committee offers a view of potential tactical allocations amongst equity, fixed income and cash, based upon a consideration of U.S. Federal Reserve policy, underlying U.S. economic fundamentals, investor sentiment, valuations, seasonal trends, and broad market trends. As conditions change, the Investment Policy Committee adjusts the weightings. The table below shows both the normal range and current recommended allocation to stocks, bonds and cash. Please consult a Baird Financial Advisor in determining if an adjustment to your strategic asset allocation is appropriate in your situation.
Appendix – Important Disclosures
This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. The information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. Foreign and emerging market securities may be exposed to additional risks including currency fluctuation, political instability, foreign taxes and regulations and the potential for illiquid markets. Historically, small and mid-cap stocks have carried greater risk and have been more volatile than stocks of larger, more established companies. ADDITIONAL INFORMATION ON COMPANIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST. The Dow Jones Industrial Average, S&P 500, S&P 400, MSCI EAFE, Lehman U.S. Aggregate Benchmark, Lehman Municipal Bond Benchmark, Russell 1000, Russell Mid Cap, Russell 2000, and Russell 3000 are unmanaged common stock indices used to measure and report performance of various sectors of the stock market; direct investment in indices is not available. Baird is exempt from the requirement to hold an Australian financial services license. Baird is regulated by the United States Securities and Exchange Commission, FINRA, and various other self-regulatory organizations and those laws and regulations may differ from Australian laws. This report has been prepared in accordance with the laws and regulations governing United States broker-dealers and not Australian laws. Copyright 2015 Robert W. Baird & Co. Incorporated. Other Disclosures UK disclosure requirements for the purpose of distributing this research into the UK and other countries for which Robert W Baird Limited holds an ISD passport. This report is for distribution into the United Kingdom only to persons who fall within Article 19 or Article 49(2) of the Financial Services and Markets Act 2000 (financial promotion) order 2001 being persons who are investment professionals and may not be distributed to private clients. Issued in the United Kingdom by Robert W. Baird Limited, which has an office at Finsbury Circus House, 15 Finsbury Circus, London EC2M 7EB, and is a company authorized and regulated by the Financial Conduct Authority. For the purposes of the Financial Conduct Authority requirements, this investment research report is classified as objective. Robert W Baird Limited ("RWBL") is exempt from the requirement to hold an Australian financial services license. RWBL is regulated by the Financial Conduct Authority ("FCA") under UK laws and those laws may differ from Australian laws. This document has been prepared in accordance with FCA requirements and not Australian laws.