Is Fuel For The Stock Rally Declining?
Sometimes the markets offer a perfect illustration of contrasts. While here in the U.S. we have been experiencing steady economic growth, the Eurozone has been firmly entrenched in a recession. Our stocks were flat this quarter, yet the Eurozone's stocks reached a 15-year high. Go Figure.
To take the contrast theme further, even modest job gains, positive consumer sentiment, and reduced cost of gas at the pump all would lead one to expect consumers to loosen their wallets and purse strings—as they have in previous economic cycles. Instead, consumer spending was selective and borrowing was more concentrated than usual—notably for auto purchases and student loans. Credit card balances increased but not at rates experienced before 2009—which is probably good. Even adding a sports car-performer like Apple Computer to the Dow Jones 30 Industrials index and removing AT&T didn't give that index much of a push around the track.
Before we delve further into details, let's take a look at how various indices fared for the past quarter.
|Dow Jones Industrials (the Dow)
|S& P 500 Stock Index (S&P 500) ||+ 0.4%|
| NASDAQ Composite||+ 3.5%|
|Russell 2000 Index (small companies)||+ 4.0%|
|Dow Jones World (non-US)||+ 3.1%|
|10-Year Treasury Bonds||+ 2.7%|
|Commodities: Dow Jones-UBS Index||- 4.2%|
|The U.S. Dollar (WSJ Index)||+ 5.9%|
All index values come from the Wall Street Journal.Stock indices do not include dividend return
While large-company stocks ended the quarter pretty much where they started, the NASDAQ Composite—dominated by large companies in the technology sector—and small companies clearly led the way up, gaining + 3.5% and +4.0% respectively. International stocks in general did well, recovering a bit of last year's losses. Foreign markets varied greatly in performance this quarter, with Eurozone stocks gaining an average +16.0% during this past quarter alone. Canada and Latin America lagged in performance, as did Asian stocks other than Japan and China. The weakness in U.S. employment reports and consumer spending held interest rates low, helping the index of 10-year Treasury Bonds to notch another quarterly gain. Thanks to crude oil's additional decline of -10.6% during the quarter, commodities lost ground. The dollar surged again, leaping to another remarkable gain of nearly +6% in this quarter.
Where We Are Now
After riding the coattails of a slow-but-steady economic recovery, equity markets have used up just about all the fuel available to them. Healthy increases in revenue and corporate profits would be quite helpful in sustaining the market's advances. Alas, initial quarterly earnings reports have been mixed. Many companies are reporting profits in line with expectations but revenues have been coming in lower than anticipated.
A common measure of the price tag of stocks—the "price-to-earnings ratio"—ended the quarter at 20.5, well ahead of historical norms. Translation: prices of stocks are expensive compared to company earnings, making them relatively expensive. Economists expect earnings for members of the S&P 500 index as a whole to actually decline 5% for the first quarter. This implies that even if the stock index remains unchanged, the P/E ratio would increase. According to both JP Morgan economists and the Federal Reserve Bank of Atlanta, 2nd quarter economic growth is expected to increase by only 0.6% and 0.2% respectively. If accurate, this would not support current high stock valuations.
On the other hand, sometimes the markets seem to tolerate high valuation without a broad selloff. The decade of the 1990's defied all logic of market overvaluation. In the 1990's, declining interest rates provided a powerful tailwind to stocks and bonds. Inflation and interest rates have remained quite low—which have provided a very positive environment for financial assets and has stimulated economic growth. However it is unlikely for interest rates to decline (though this is possible). At the cost of lower oil sector employment and reduced spending within the energy sector, low fuel costs have helped provide their own form of stimulus for energy consumers. Oil executives expect lower prices for an extended period of time.
Consumer sentiment has been positive yet consumer spending has been lower than expected—auto sales and restaurant dining being the exceptions to reduced spending. Consumers have apparently "found religion" and decided to put away some of the savings from lower gas pump prices. After three straight months of decline, seasonally adjusted retail sales increased + 0.9% in March but were lower than expected. As more evidence of an economic slow patch, industrial production for both the month of March and for the most recent six months has declined. Part of this is due to the stronger dollar which makes our products more expensive to foreign purchasers (and our purchases of foreign goods less expensive).
There is currently a higher level of international risk than there has been for some time. The threat of further declines in international markets in response to the ongoing Greek drama of "willful child versus parental purse strings" remains. If Greece finally defaults and exits the European Union, there may be a shudder in the financial markets worldwide until an adjustment to the outcome is complete. China's stock market could experience its own "crash" since their stock market is up 100% over the last 12 months—including an increase of over 70% year-to-date! Either or both of these events could drive our markets down. In other words, shocks to the Eurozone or China would have at least a temporary ripple effect upon our markets and would drive the dollar even higher.
If our economic growth rate eases but doesn't decline, we could ride out this period of overvaluation without a major correction. Given the economy's deceleration, the Federal Reserve may delay increasing short-term interest rates until after June, as was previously expected. The risks that Greece and China pose to global markets could have a significant bearing on our stock market.
Low inflation and low interest rates—as well as the presidential election year cycle—normally favor the stock market as the promises and maneuvers intended to woo voters elicit a positive response from investors. However, the high market valuation and international risks may mute this normally bullish trend.It would not be surprising for stocks to take a short-term "breather" to allow the economy and corporate profits a chance to catch up to current market valuations before further advances are achieved.
As always, we will continue to follow the markets closely and will take appropriate actions within client accounts to manage risk and return in accordance with each client's respective Investment Policy Statement.
Please feel free to call with any questions or comments.