In last week’s Market Commentary, we suggested that investors have become emboldened to own stocks based on improving economic data as well as the implied safety net of the Fed’s quantitative easing programs. While we still believe this is the case, it is also clear that investors are not jumping into stocks with both feet. Rather, the evidence tells us that investors have carefully and cautiously rotated out of some fixed income investments and into the relatively more attractive and defensive blue chip stocks. In a continuation of this discussion, this week we talk about exactly what investors are favoring within the universe of stocks.
The action in the stock market this year reflects an economy growing at a modest pace, coupled with a cautious investor base that desperately seeks acceptable returns in an ultra-low rate environment. Investors increasingly recognize the need to be invested in stocks given the ridiculously low yields available in the bond market. In fact, the Fed’s nudging of investors out of bonds and into stocks through monetary policy is perhaps the best explanation for the S&P 500’s 10%+ increase year-to-date through yesterday. However, investors clearly remain cautious nonetheless. The degree of caution among stock investors is perhaps the single-biggest reason we have not seen a meaningful correction in stocks over the past several months. Paradoxically, corrections tend to occur when the consensus outlook for stocks becomes overwhelmingly positive. The rationale is that once optimism becomes nearly unanimous, most investors have already established their long positions and there are few incremental buyers for stocks!
So how do we know that there is still significant caution among the investor base? I’m glad you asked! In order to get a read on the investor’s mindset, we like to look at stock returns by market sector from time to time. In fact, an article in today’s Wall Street Journal (”Stocks Hit New Highs”, by Jonathan Cheng) spoke about these very trends. To paraphrase, the sectors leading the market higher this year are those generally considered the most defensive and least cyclical. Health Care, Consumer Staples, and Utilities are each up in the low- to mid-teens this year, reflecting an investor that seeks safety and dividends. At the same time, those sectors that are most cyclical (ie, dependent on a strong economy) have been the worst performing sectors so far this year. Materials, Information Technology, Industrials and Energy are up only about 5.5% on average this year. The relative weakness among these groups signals that investors aren’t ready to make a definitive bet on an acceleration in economic growth just yet. In addition, investors may be worried about tail risks - such as renewed problems in Europe or failure to reach a budget agreement in the US - that could potentially spark a sell-off in these more volatile areas of the market.
The graph (source FM&W) below shows the performance of each industry sector within the S&P 500.
What are some other indicators of cautious sentiment? More recently, we have seen a pull-back in the Dow Jones Transportation Index as well as shares of small-capitalization stocks. As the Wall Street Journal noted, the DJ Transportation average is down 3.6% so far this week even as the overall market hovers close to new highs. Similarly, the Russell 2000 index, which is the most widely used barometer for small cap stock performance, is down 3.0% this week. Given that these two sectors of the market tend to lead the overall market (while being more volatile in general), investors might want to hunker down for a little while.
One final indication of the lack of investor conviction is trading volumes. In the first quarter of 2013, trading volumes were down about 7% compared to the first quarter of 2012. Generally speaking, if investors have strong conviction about the future direction of stock prices, trading levels will reflect this conviction. Since we haven’t seen the increase in trading volumes, we can only conclude that there isn’t much conviction.
As we have suggested many times over the past several months/years, stocks are increasingly being viewed as a more attractive investment alternative than bonds. While this is not necessarily a bad thing, it is not necessarily an indicator of continued strength either. What we can glean from this year’s trading action is the following: 1) nobody is really expecting a dramatic improvement in economic growth anytime soon; and 2) the gains we continue to see in stocks are heavily dependent on the Fed’s aggressive monetary policy. Given these two conclusions, we remain defensive as well.
The US dollar index, which measures the value of the dollar relative to a basket of six major foreign currencies, has increased over 5% since the beginning February. While this may not sound like a big move, it is actually quite significant for such a short period of time. The move into the US dollar reflects continued uncertainty in Europe (”flight to quality”) as well as the improving economic data we have received in the US over the past few weeks. Investors are especially encouraged by the recent housing data, which continues to suggest that this important sector of the economy is on the mend. Indeed, it appears that the US is becoming an even fancier house in a still-impoverished neighborhood.
Getting back to my point…The last time we saw a dollar strengthening of this magnitude was during the month of May, 2012. That month, too, was characterized by renewed fears about problems in Europe. There was widespread speculation that Greece might leave the European monetary union. Some also thought that a Greek exit would trigger a contagion, leading to other departures and the ultimate dissolution of the monetary union. In our March 23, 2012 Market Commentary, we wrote the following:
“Markets around the world continue to be volatile in response to concerns about the situation in Europe. As the value of “risky” assets has been falling in recent weeks, money continues to pour into the safety of the US dollar and US Treasuries. The US Dollar Index (ticker symbol DXY), which is a measure of the value of the dollar against a basket of six major currencies, is trading near a 20-month high. The yield on the 10-year Treasury note, which moves in the opposite direction as the bond’s price, is now close to a record low at 1.74%. Investors continue to display an insatiable appetite for an asset that will not yield enough to cover the expected rate of inflation, resulting in a loss of purchasing power. While this type of irrational investor behavior cannot go on forever, it does signal that investors are protecting against some very nasty tail risks. This European problem just won’t go away.”
While the recent flair-up involving Cyprus may not be as threatening as the Greek drama experienced last year in May, it also seems that investors have become somewhat desensitized to the issues across the pond. Prior to this year, sharp increases in the dollar index (reflecting European fears) were generally accompanied by a sharp rally in US Treasuries and the indiscriminant selling of stocks. This knee-jerk reaction to exogenous shocks came to be known as the “risk-off” trade because any security containing risk was shed in favor of those offering principal security.
This time around, however, investors don’t seem to be so alarmed. While the dollar has appreciated by a similar magnitude as last May, Treasury yields have fallen less than half as much, and stocks have actually appreciated in value. The chart below graphically displays the differing market reaction to the crises. From this chart, we can draw one of two conclusions: 1) either (and quite possibly) the European situation is not the threat it once was, or 2) investors have become much more risk-tolerant.
But there is a third possibility that makes more sense to us. It seems to me that there has been a change in investor perception about the inherent riskiness of stocks in this environment. In my view, investors have become emboldened to own stocks based on both improving economic data as well as the implied safety net of the Fed’s quantitative easing program. Therefore, crises that shake investor confidence do not necessarily lead to indiscriminant selling of US stocks anymore. At the same time, investors may be warming to the notion that the ownership of long-term bonds in a period of unprecedented money-printing entails its own amount of risk. A sharp rise in inflation, and therefore interest rates, could lead to substantial losses in bond portfolios. Stocks offer at least some protection against this scenario.
We will repeat what we said nearly a year ago when stocks swooned in reaction to renewed European problems: high-quality US blue chips stocks appear to be a sensible investment alternative in this environment. With interest rates as low as they are, the risks of owning stocks in high-quality companies with outstanding balance sheets may not be as high as the interest-rate risk associated with the ownership of long-term Treasury bonds. Perhaps investors are getting more comfortable with this notion. Having said that, stocks are not inexpensive anymore following a massive rally over the past four years. Careful research is as important as it’s been in quite a while.
The Federal open Market Committee released a statement summarizing its day and a half of deliberations, saying it sees “a return to moderate economic growth following a pause late last year. Labor markets have shown improvement in recent months, but the unemployment rate remains elevated…the housing sector has strengthened further, but fiscal policy has become more restrictive.” It is a message of some improvement, a new headwind, and unchanged monetary policy. The Committee will continue monthly purchases of $85 billion.
On the heel of Cypriot bank-deposit delirium, we suspect that the US central bankers had more than enough concern to hold firm to the seemingly limitless flow of monetary easing.
Last weekend the European Central Bank cooked up a plan to provide Cyprus with a necessary bailout but required that all bank deposits be taxed at a rate of up to10%. Imagine waking-up to your morning paper explaining that 10% of your bank accounts had just been confiscated. Because of the weekend, citizens rushed to ATMs and withdrew everything they could. When this lead balloon sent crash reverberations around the world, Cypriot banks remained closed and may reopen on Thursday.
In other Central Bank activity, the results of stress tests were released for US banks with all but a very few doing well. When we consider what really allowed markets to recover in spring 2009, we recognize that the concoction and execution of the bank stress tests really turned the tide. Upon closer and calmer reflection, it was a time when faith and trust in the US banking system was in decline. Using the vehicle of a stress test that was only generally defined (and for which the detailed results were never made clear), the Federal Reserve told the world that the banking system was sound, and we believed them. In essence, our take is that the Federal Reserve, as the lender of last resort, properly resorted at a moment of extremis to lend its trust and confidence to the banks. It was much more important than money.
The ECB came very close to undermining the trust and good faith of the European banking system. It may have been one of the worst blunders in its history. Though they have averted the blunder for the time being, their reputation has suffered for even considering it. The ECB has called into question the sanctity of bank deposits. Can this genie be put back in the bottle?
As the Federal Reserve’s balance sheet approaches $4 trillion and deficit spending continues, investors are happy. Addicts are always happy when the drugs and booze are plenty and the consequences nil. Keep up the intake, avoid death and morning, and they’re all set!
Markets renewed their rally after the Cyprus and FOMC news passed. Bonds fell, while stocks, commodities and the Euro dollar rose.
When conditions are this conditional, there is no reason to swing for the fences. Investors must understand what they own, why they own it, and what makes it valuable. This is easier said than done. This market seems intent on moving higher. We are nervous but don’t hear any large lasses singing.