Take Me to the Top
The most common question we have been getting as of late is when is the market pullback going to occur? Stocks are up over to 200 percent from the March 2009 bottom and 75 percent from the most recent market correction (of 15 percent) in October 2011. While it has been almost three years since a major correction, history has shown this trend can continue for quite a bit longer. To that point, Cornerstone Macro Research gathered some data on previous market pullbacks which are highlighted in the chart below.
History shows that there have been numerous periods of much longer durations when stocks have climbed without a major pullback. If you simply look at the fundamentals of the stock market, an argument can be made that the S&P 500 can continue to move higher without a meaningful pullback. First, U.S. economic growth is improving and global GDP should continue to trend in the mid-single digits, resulting in continued earnings growth. Second, with low inflation and low interest rates, the valuation of the equity market is still attractive and the Price-to-Earnings multiple of the S&P 500 still has room for upside from 15.6x at present. While there will always be unforeseen shocks, the risks in the system are not as predominate as we saw in 2011 (Europe debt crisis, U.S. debt downgrade, Fiscal austerity) or 2000 (stretched valuation, falling consumer sentiment, manufacturing data weakening). However, risks that investors should be cognizant of are a spike in oil prices due to Middle East tensions, China’s economic growth slowing meaningfully, and an adverse reaction to Federal interest rate hikes in 2015.
What Do You Do For Money?
Earnings kicked off this week with mixed results from large cap technology. Specifically, there was divergence within the internet ad space, with Google growing and Yahoo stagnant. One wonders how long the Yahoo board will give CEO Marissa Mayer to achieve the turnaround. Intel delivered a strong quarter due to PC upgrades primarily from businesses as Microsoft sunsets its client support for Windows XP. This strength is allowing the company to return cash to shareholders through an announced $20 billion repurchase plan. While Intel stock reacted very favorably to the announcement, it was disconcerting that their mobile business continues to underachieve. This division lost over $1 billion while grossing a mere $51 million in revenue (down from $292 million a year ago). Intel’s move into this area looks to have been a failure which leads us to speculate where they will have to make an acquisition in order to penetrate the market.
Takeaways for the Week
- The start of the earnings season has resulted in no major market moving results
- Tensions in the Middle East and Ukraine may have a minor effect on U.S. markets, and unless we see a spike in oil, they should not hinder economic growth
We are pleased to present our Investment Outlook: Third Quarter 2014 video titled, “Back on Track.”
This quarter, Chief Investment Officer George Hosfield, CFA, discusses how despite starting the year with a winter-induced swoon, the equity markets have nearly realized the “average annual return” that we predicted in January for the entire year. That said, we believe that an improving labor market, a strengthening economy, rising earnings, low interest rates and reasonable multiples provide a backdrop for further equity gains.
To view our Investment Outlook video, please click here or click on the image below.
We have illustrated below the details of the convergence of government bond yields between the stronger credits of Germany and the United States versus the weaker credits of Italy and Spain. Germany and the United States are arguably two of the strongest sovereign bond insurers in the world. While not perfect, both Germany and the United States have dynamic economies with reasonable levels of inflation versus economic growth. Also, both countries have excellent ability to pay their debts and are viewed as “safe haven” credits by bond investors.
Italy and Spain are a different matter. While we do believe that these countries are starting to recover from the European debt crisis, there are still many structural economic issues that need to be addressed. For example, Italy has a 12 percent unemployment compared to the six percent unemployment in the United States. However, Italy’s unemployment looks very favorable compared to the 25 percent unemployment currently in Spain. In addition, both of these countries have severe demographic issues with aging populations and strict labor market regulations that make the labor force less flexible.
What changed to cause interest rates to drop from around the seven percent for a 10-year bond for Spain and Italy in 2021 to the less than three percent rate of interest they now pay were the actions by the European Central Bank or ECB. Essentially, the ECB, which is akin to the Federal Reserve for Europe, announced they would do whatever it takes to backstop these countries. These words gave bond investors the confidence that Italy and Spain will have the ability to honor their debt obligations. Financial markets run on confidence, and this was enough to cut the borrowing costs of these countries by half.
Countries compete for capital from investors. Investors strive to get the best return for the risk that they are taking. Given this set of facts, buying United States treasury bonds versus European country debt seems like a much better investment from a risk versus reward standpoint. While the words of the ECB do merit more investor confidence, there is still underlying credit risk that does not seem to be properly priced into European government debt.
This week there was an event in Portugal that highlighted this risk. During the European debt crisis, Portugal was in a similar position to Italy and Spain. Portugal had a heavily indebted economy with structural economic issues and a high cost of borrowing based on perceived credit risk. Portugal fell under the ECB umbrella and their borrowing costs have declined in a similar fashion to Spain and Italy. However, this week Portugal’s Banco Espirito Santo announced that they were having issues meeting debt payments on some short-term borrowing the bank had done to fund operations. This news was enough to cause a one day .30 percent increase in the yield of the Portuguese 10-year bond and a broader decline in European stock markets. While relatively minor, this incident demonstrates the market confidence in European sovereign debt markets is on the razor’s edge and credit risk is probably not properly reflected in the possible risk of this debt.
Our Takeaways for the Week
- U.S. Treasury debt is more attractive than European sovereign debt
- While we do believe interest rates will rise in the U.S. as economic growth continues, there is a cap on how high interest rates will climb. Investors will favor U.S. Treasury bonds over European bonds which will help keep rising rates in check