The Bull Market Goes On, From Bob Doll, vice chairman and chief equity strategist, BlackRock
Last week was difficult for equity markets as ratings downgrades on European sovereign bonds raised fears of credit contagion. Last week also brought news that US gross domestic product (GDP) had grown at an estimated 3.2% pace in the first quarter, indicating that the US economy continues to recover at a moderate pace. While some sectors (such as consumer spending, business investment, equipment and software, and inventories) are providing strong momentum, other variables (including private nonresidential construction, international trade and state and local government spending) are acting as a drag. In all, the report confirms our view that the economy is transitioning from a government-aided recovery to a self-sustaining expansion. The key factor remains growth in private sector jobs; we expect to see moderate growth.
Also in the news last week was the Federal Reserve’s policy meeting, in which the central bank maintained its position on interest rates. Attention is increasingly turning to when and how the Fed will move from its current emergency stance. As we have been saying for some time, we expect the Fed will begin signaling an increase in rates before too long, with higher rates likely by the end of the year.
Corporate earnings continue to be strong. At this point, it appears first-quarter earnings on the S&P 500 will be slightly above $20 per share. The improvements are a reflection both of cost cutting and increases in revenues. At this point, it looks like full-year 2010 earnings could come in somewhere between $85 and $90 per share, just shy of the peak of $92.
Spreads on Greek and other sovereign debt in Europe rose to new highs last week. The broader question for investors is whether the events in Europe signal a disruption in the global economic recovery and an end to the bull market in risk assets. Our answer to this question is “no.” The IMF and EU packages should alleviate at least some of the issues. To date, the problems of the sovereign debt crisis, global policy tightening and regulatory restrictions have been outweighed by the broader improvements in the global economy and rising corporate profits. Given the low returns offered by cash and the still-reasonable valuations for stocks, we expect that this trend will continue.
Reasons to Stay Invested, from Liz Ann Sonders, chief investment strategist, and Brad Sorenson, director of market and sector analysis, Charles Schwab and Co.
"Don't fight the tape" is a phrase often heard by pundits on Wall Street, and the current rally has illustrated that the "trend is your friend." Of course, the stock market will continue to look good until it doesn't anymore—not great insight, but illustrative of the futility of trying to time the market. Investors who've been waiting for a "correction" to put money to work in the market have watched a steady climb higher as they sit in cash—earning next to nothing.
Pundits have been calling for a correction for weeks now, but it must be noted that can be accomplished through time or price. With the recent churning action of the market during a relatively robust first-quarter earnings season, we believe we saw at least a partial correction in terms of time. Positive earnings results and outlooks with little price movement allow the fundamentals underlying the market to catch up to the price action.
Of course, a price correction can occur at any time and exogenous events can happen at any time to rattle the markets—suggesting that investors would be wise not to push all of their cash into the market at one time, but rather to average in over several months to smooth out some of the volatility inherent in the market.
We've been encouraged by the resilience of the market in the face of numerous challenges. Fraud charges by the Securities and Exchange Commission (SEC) against a major investment bank, continued eurozone concerns (centering around Greece, Spain and Portugal), financial regulation concerns, a slow return to normalization by the Federal Reserve and tightening by numerous foreign central banks haven't been enough to knock the market back too far. We continue to believe the economic recovery is underappreciated and enough skepticism remains to leave us relatively optimistic on the market's prospects for the next few months.
From David Rosenberg, chief economist and strategist, Gluskin Sheff
TEN REASONS FOR A DOSE OF CAUTION
- Markets were unimpressed with the size of the just-announced $145 billion rescue package or the ability of Greece to meet the terms. A bailout of all Club Med countries would, according to estimates I’ve seen, approach $800 billion. This is bigger than LEH.
- China raised reserve ratio requirements 50bps for the third time this year (to 17%). A decisive slowing in China and the U.S.A. is a crimp in the near-term commodity price outlook.
- Australia just unveiled a massive new mining tax. This is weighing on material stocks overnight.
- Possible criminal probe on Goldman weighing massively on the stock price; financials being re-rated by rising specter of financial re-regulation. Shades of Sarbanes-Oxley. There has never been a financial crisis that was not met afterwards with regulatory reform — it’s how the SEC was created in the first place.
- ECRI leading economic index just slipped to a 38-week low. With the restocking phase complete and fiscal stimulus waning, prospects of a second half slowdown loom large. Buy the recovery story when ISM is at 30 and policy stimulus in full swing (13 months ago); fade it when ISM approaches 60 and stimulus subsides. Market Vane sentiment is pushing towards 60% too — yikes! Too much priced in. As for the macro scene, the U.S. economy is barely growing at all, net of all the federal stimulus (+0.7% SAAR in Q1). And net of housing impacts, neither is Canada … should set us up for a fascinating second-half.
- Attempted terrorist attack in Times Square a reminder that geopolitical risks have not gone away.
- Treasury yields have collapsed nearly 35bps from the nearby highs and are not consistent with the recent move by equities to price in peak earnings in 2011. Junk bonds trading back to par for the first time in three years.
- The U.S. implicit GDP price deflator receded to its slowest rate in 60 years in Q1 (+0.4% from +2% a year ago) in a sign that this profits recovery is still being underpinned by cost cuts, tax relief and accounting shifts than by anything exciting on the pricing front.
- The latest Case-Shiller house price index confirmed that we are into a renewed leg down in home prices. Financials, retailers and homebuilders are not priced for this outcome.
- Initial jobless claims, around 450k, are not consistent with sustained employment growth, notwithstanding what nonfarm payrolls tell us this Friday. A new peak in the unemployment rate and a new trough in home prices stand as the most pronounced downside surprises for the second half of the year.
Mortgage Bonds: Worth a Second Look, from Anthony Valeri, market strategist, LPL Financial
For investors seeking government bond exposure we prefer MBS to Treasury and traditional agency debt. While we continue to prefer corporate bonds on a broader level, the added yield provided by MBS is still notable given the low overall level of government bond yields. We expect yield spreads, or valuations, to extend their recent stability and show only modest weakness, if any, over the coming months.
Several factors have been responsible for yield spreads, a measure of valuations, remaining near historically narrow levels:
•Low bond market volatility.
•The highest yielding government bond option in a low-yield world.
•Fannie Mae buy-outs of delinquent loans.
•Light institutional exposure.
•Low net supply.
Bond market volatility has declined steadily and remains near the lowest levels since the start of the financial crisis in mid-2007. Lower bond market volatility is a positive for MBS holders since it reduces the variability of MBS cash flows to investors. The reduced uncertainty causes investors to push up the price of bonds and reduce the spread, or yield advantage, to comparable Treasuries.
Conversely, high volatility, in the form of big shifts in interest rates, in either direction, increases uncertainty. Should interest rates drop sharply, the underlying residential mortgages may be refinanced by homeowners thereby greatly shortening the life of the bond. If interest rates spike higher, refinancing may dry up entirely leaving investors with a much longer-term bond than initially anticipated since homeowners will have little incentive to refinance.
Although yield spreads remain near historically low levels, the current 1.2% yield advantage to Treasuries is still notable in a low yield world. Among government bonds, MBS remain the most attractive option in our view.
Help Clients Stay the Course, from Stephen J. Huxley, Ph.D., chief investment strategist, Asset Dedication
The stock decline of 2008 caused investors to question their asset allocation and dramatically change the way they invest their nest eggs. According to the 2009 Morningstar Fund Flows and Investment Trends annual report, from 2001 through 2008, the flow of cash into bond funds totaled $527 billion, or about $66 billion per year. In 2009, in a flight to less volatile investments, $357 billion poured into bond funds, more than the prior five years combined. Stock funds, on the other hand, saw $68 billion flow out.
Unfortunately, this shortsighted view of capital markets causes investors to be their own worst enemy—by trying to time when to get in and out of the market. The Barclays Capital Aggregate Bond Index returned a solid 5.9% in 2009. But the S&P 500 Index popped back up 26.5% in 2009, recovering much of the 37% drop in 2008. In other words, investors who stayed with their stock allocations were able to claw back much of their losses. But those who switched to bond funds are still underwater at a much deeper level while they wait for the “right” time to jump back in to the market. If interest rates rise, their meager gains from 2009 could be wiped out entirely and their capital losses decline further.
This looming specter may make things even worse for investors who have chosen to sit out the equity markets in bond funds. Rising rates will keep total returns modest and can even lead to losses, which will catch investors who don’t understand the bond market off-guard.
Getting whipsawed, first by stock losses, then by bond losses, adds to the already enormous mountain of evidence against market timing and highlights the real purpose of advisors: keeping clients invested. The key is not only identifying an asset allocation that gives clients a better chance of reaching their financial goals, but also structuring a plan that keeps them invested when markets stumble. The hard part is not the quantitative calculations. It is developing a strategy that bolsters their behavioral fortitude so that clients stay invested through difficult markets and curb their instincts to make the wrong decision at the wrong time.
Think Local, Invest Global, From Dorsey D. Farr, principal, French Wolf & Farr
Western Europe, the UK, Japan, and the United States share many traits in common. They are all large, well-developed economies with robust banking and financial systems. However, like our peers in the developed world, the U.S. has a demographic problem, an excessive budget deficit and accumulated debt, an unsustainable social safety net which has just been greatly enlarged, and our tax burden is headed higher. While the U.S. remains the most dynamic economy in the developed world, its uniqueness and dynamism seem to be fading with each passing day.
One area where similarities have increased in recent years is the mobility of labor. Cross-border labor immobility has long been cited as one of the problems with the Euro currency. In the U.S. labor moves relatively freely across state lines, especially during periods of economic expansion. However, the housing bust and deep recession have restricted labor mobility in the U.S., since workers are often stuck in homes with market values below the value of outstanding loans. Add labor immobility (along with 9.7% unemployment) to the growing list of features we share in common with Old Europe. A value-added tax may be next.
Once one embraces this reality, it is hard not to question the 25-30% premium investors currently pay for U.S. equities relative to shares on other major exchanges. All major global exchanges are populated by large, multinational firms with geographically diversified revenue streams, which ought to reduce cross-border valuation spreads. Long-term investors can count on these valuation gaps closing over time, which suggests taking most of your equity risk overseas despite the current concerns about sovereign risk.
REPORTS CALENDAR
Monday, May 3:
April Motor Vehicle Sales; April ISM Manufacturing Index; March Construction Spending; March Personal Income and Expenditures
Tuesday, May 4:
Same-store Retail Sales (weekly); March Factory Orders; March Pending Home Sales
Wednesday, May 5:
Treasury Refunding Announcement; Mortgage Applications (weekly); April ADP Employment Report; April ISM Non-Manufacturing Report
Thursday, May 6:
Jobless Claims (weekly); First-Quarter Productivity and Labor Costs
Friday, May 7:
April Non-Farm Payrolls; March Consumer Credit
