Are Investors Buying into the Equity Story?

Stocks Climb in Quiet Week

Stocks inched higher last week amid limited economic data and the start of Q4 earnings season. The S&P 500 increased 0.4%, while the Dow Jones Industrial Average rose 0.5%.

Earnings season got underway last week with mostly encouraging reports from Alcoa and Wells Fargo. Alcoa posted a profit and reported revenue that topped analyst expectations. The aluminum-maker also forecasted aluminum demand would increase in 2013. Wells Fargo beat estimates after posting a 24% rise in earnings, but the stock declined due to compressed margins and a drop in mortgage volume. There are concerns Wells Fargo’s margin data is symptomatic of the broader industry, which led to a modest decline in banking stocks in Friday’s trading session.

Current estimates call for a pickup in earnings growth relative to the previous quarter.

FactSet analysis shows the index is projected to post a 2.6% gain. The S&P 500 managed to eke out a slightly positive result in the third quarter as the final reports trickled in, narrowly avoiding an end to an 11-quarter streak of positive earnings growth.

The National Federation of Independent Businesses (NFIB) released its monthly Small Business Optimism Index on Tuesday. Following a plunge of more than five points in November, the index recovered only 0.5 points in December to 88.0, the second lowest reading since March 2010. December’s reading was in line with consensus expectations.

Underlying responses of the survey were not encouraging – an unsurprising result since the index is in recessionary territory. A full 70% of respondents reported that they felt the current period was a bad time to expand. A quarter of those noted that political uncertainty was the primary reason. NFIB Chief Economist Bill Dunkelberg pointed to the role of Congress’ indecision over the fiscal cliff in weighing on small business productivity in the month.

The US trade balance unexpectedly widened in November by more than $6 billion. This was at odds with forecasts of a slight narrowing. Although exports increased in the month, a surge in imports of consumer electronics, pharmaceuticals, and autos led to the increase. Reports indicate that imports of Apple’s iPhone were the primary driver behind the surge, as the company’s recently released iPhone 5 saw robust demand ahead of the holiday season.

The pace of positive surprises in US economic data has slowed markedly in recent weeks. The Citigroup Economic Surprise Index (CESI), which measures economic data levels relative to consensus expectations, has recently rolled over and appears headed for negative territory. This indicates that economic data is coming in weaker than analyst forecasts; Friday’s disappointing trade data was one factor driving the index lower.

The recent trend in the CESI is a discouraging development for investors. The index has historically tracked the equity markets to a large degree, with market sell-offs coinciding with negative readings in the fall of 2011 and in May 2012.

Despite the lack of economic reports domestically, there were some important releases internationally during the week.

In Europe, the Eurozone reported that the monetary union’s unemployment rate ticked higher to 11.8% in November. This is a record high level, propelled higher by a staggering 26.6% rate in Spain. Germany’s rate was unchanged at 5.4%, but France saw its jobless measure creep higher to 10.5% during the month. Despite relative optimism by many market participants about Europe, as evidenced by falling sovereign yields in many peripheral countries, November’s data underscores continued severe economic distress in the region.

A pick up in Chinese inflation in December weighed on risk assets later in the week. The country announced consumer prices increased by 0.8% in December, a sharp jump from November’s 0.1% rate. The rise was caused by an increase in food prices, particularly vegetables that were impacted by cold weather.

After steadily declining over the past 18 months, the recent uptrend in Chinese consumer prices is a source of concern for many market participants. The year-over-year rate has increased during the past two months, causing many to fear the country will have to pull back on stimulative infrastructure programs. Still, at 2.5%, the current level of year-over-year inflation is well below the 6%-plus levels seen in mid 2011.

are investors buying into the equity story?

Last week we discussed the debate over active versus passive management. We believe active managers can add tremendous value in particular segments of the market, despite recent challenges. Outside of the active management discussion, many investors are deciding whether equities are a prudent place to allocate capital at this point in the market cycle. The first week of the year answered investors’ opinions on that question loud and clear.

To start the year, investors bought into equities in a big way. More than $22 billion was deposited in equity funds, the second largest inflow since data has been captured.

Source: Business Insider

The strange thing about last week’s record equity flows was that bond flows failed to materially slow. Fixed income funds added another $6.5 billion, according to Bank of America Merrill Lynch. Strategists are of the opinion that 2013 could be a year when investors undertake the great rotation out of bonds and into equities. Investors, particularly those nearing retirement, still have income needs, however, and bonds are one of the few ways to satisfy that need.

Source: Business Insider

For equity investors, the recessionary and slower growth environment internationally resulted in few opportunities to add differentiation last year. In Fidelity’s latest business cycle analysis, though, they surmise that China is in the early stages of economic growth, the US is in the middle innings, and countries like Germany are in the late portion of the cycle.

Typical business cycle

Source: Fidelity Investments

Given the stage of the business cycle and the backdrop for equity investing, active equity managers could find themselves in a good position. It is important to remember that active managers, just like many things in life, go through cyclical periods of being in and out of favor. A recent analysis from Wellington Management showed that on a rolling three-year basis, active managers generally outperform in most environments, but there are periods of difficulty. Wellington concluded that a series of headwinds is affecting managers, but those headwinds are slowly abating.

Source: Wellington Management

That bodes well for active equity strategies, but it is entirely possible that this year, much like the past several, will be marked by bouts of volatility. Around the debt ceiling debate in August 2011, equity markets lost more than 15%. The debt ceiling will once again become a focal point for investors towards the middle of the first quarter, and just as the fiscal cliff influenced markets, so too could the debt ceiling talks.

Source: BCA Research

Based on recent strategist discussions, 2013 looks to be the year of the stock. Such cohesion and agreement is rarely a positive for an investment, but there are reasons to think that the current path of low inflation, moderate economic growth, and declining uncertainty will bode well for equities this year.

the week ahead

Economic data picks back up this week with several releases spanning the consumer, housing, and manufacturing sectors. Notably, retail sales are due on Monday and housing starts are slated for Thursday. Inflation data is also on tap with the producer and consumer price indices scheduled for Wednesday and Thursday, respectively.

Earnings season kicks into high gear as six Dow and 37 S&P 500 companies are due to report earnings this week. The bulk of S&P reporters are financial companies, including J.P. Morgan, Goldman Sachs, Bank of America, and Citigroup. Other notable companies include GE, eBay, Schlumberger, Intel, and American Express.

On the central bank front, Russia, Brazil, Serbia, Chile, Colombia, and Mexico release interest rate policy this week.

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