Too Great Expectations

Executive Summary

Global investors entered the year with newfound enthusiasm. Across the board, global equities traded higher in January, and retail money flows into global equities were the best in 17 years.1 Media reports about a “Great Rotation” from fixed income into equities are raising expectations about the possibility of a new secular bull market. However, I believe a little perspective is in order.

  • Overweight US. There are plenty of reasons to remain bullish about US equities. But seasonal weakness and the disconnect between the current optimism and economic indicators suggest some potential weakness in the weeks ahead.
  • Underweight Europe. Recent currency strength could threaten the recovery and negatively impact corporate profits. Uncertainty about the potential recovery is likely to limit further equity gains until fundamentals are more supportive of current prices.
  • Neutral weight Japan. A change in leadership at the Bank of Japan (BOJ) is expected to move the central bank closer to implementation of unlimited quantitative easing. Recent gains in the Nikkei 225 Index were in direct response to movement in the yen/dollar exchange rate, in my opinion. However, there could be an unintended consequence of a weaker yen: inflation, which has historically been unfavorable for Japanese equities.
  • Overweight emerging markets. Emerging equity markets have been among the prime beneficiaries of developed markets’ quantitative easing programs, and they could continue to benefit once Japan joins the fray. However, liquidity has been known to create asset bubbles — which have ended badly in this region in the past — although we aren’t there yet.

The following expands on these insights and examines implications for global equity investors.

Equities remain attractive but upside may be limited

The global equity markets roared into the new year as investors forgot about their troubles, anxiety and fears. The MSCI World Index, up 5% in January, had its best start since 1994.2 The MSCI Europe Index had the best start since 1998, also up 5% in January.3 As of February 1, Japan’s Nikkei 225 Index was up 12 consecutive weeks, which it hasn’t done in 53 years.2 China’s stock market (as represented by the Shanghai Stock Exchange Composite Index) rose 24% in the past two months, and the S&P 500 Index was up 5.04% in January, for the best start since 1997.2

US investors have been downright giddy. Retail investors poured $34.2 billion into the global equity market (including exchange-traded funds, or ETFs), according to Lipper data — an allocation shift unmatched in the past 17 years.1 Some pundits and strategists are talking about a Great Rotation of assets from fixed income into equities and predicting the beginning of a secular bull market and high double-digit returns this year.

Granted, I was bullish on equities over the past year. Yet without some further perspective, I believe investors could get carried away with the possibility of the “mother of all bull markets.” This month’s commentary focuses on why I believe expectations have gotten ahead of current fundamentals.

US: overweight

On one hand, the S&P 500 Index seems poised for higher levels.

  • Since 2009, the S&P 500 Index has been 85% correlated to the balance sheet of the Federal Reserve’s (the Fed), and its policy-making body, the Federal Open Market Committee (FOMC), has made no plans to end its $85 billion monthly purchases of mortgages and government bonds.4
  • Over the past 63 years, when the equity market was up more than 4% in January, the market was positive for the year 92% of the time, with an average return of 12.65%.5 Of course, past performance is no guarantee of future results.
  • The long-term earnings growth currently priced into the S&P 500 Index is indicating pessimistic sentiment, whereas optimism is priced into options on the S&P 500 Index and the euro/US dollar (USD).6 These disconnects could point to additional upside potential from current levels.
  • The Dow Theory also suggests higher levels for the equity market. This is a technical indicator that postulates that when the Dow Jones Industrial Average (DJIA) and the Dow transport stocks make new highs and move in sync, the DJIA is expected to continue to move higher. Over the last 15 years the only false Dow Theory signal occurred during the “Flash Crash” in May 2010, when the DJIA plummeted roughly 1,000 points but recovered the losses within minutes.7

That said, for stock prices to hold and move higher, the improvements in financial conditions and investor optimism need to feed into the real economy. But that’s the problem: Fundamentals do not appear to be moving in the right direction, whether we measure real time or leading indicators. Therefore, the risk-reward profile of equities is becoming less attractive, making a period of consolidation increasingly likely.

The lack of economic growth could limit the equity market’s upside. Here are my concerns:

  • For the first time since mid-2009, gross domestic product (GDP) growth was negative, registering -0.1% (quarter over quarter) in the fourth quarter of last year.8 The year-over-year trend in nominal GDP (not adjusted for inflation) was 3.3% in the fourth quarter, the lowest growth rate in three years and not far from the levels seen in the 1982, 1990 and 2001 recessions.8
  • The Conference Board’s Leading Economic Index (LEI) year-over-year percent change has declined three months in a row.9
  • The Conference Board’s coincident-to-lagging ratio, which actually “leads the leader,” has declined in two of the past three monthly readings to its lowest level since October 2009.10 Over the past 10 years, GDP has been 93% correlated to this indicator.10
  • The Institute for Supply Management (ISM) Manufacturing Index spiked to 53.1 in January from 50.2 the previous month, suggesting the economy is expanding and growth is accelerating.11 However, the ISM reading defied the negative Empire State Manufacturing Survey, the Federal Reserve Bank of Philadelphia Business Outlook Survey and the Federal Reserve Bank of Richmond Survey of Manufacturing Activity for January, which pointed to an ISM reading of 46.4.12 The recent positive ISM number looks suspect, in my opinion.
  • The Citigroup Economic Surprise Index for the US is in negative territory as of the end of January.13 This index measures how major economic announcements actually come in relative to expectations.

Furthermore, consumer spending, the key driver of the US economy, is likely to come under pressure in the months ahead, with declines in payroll growth, rising gasoline and food prices, higher mortgage rates and the fiscal drag. The Thomson Reuters/University of Michigan Consumer Sentiment Index, which has done a decent job of predicting consumer spending growth (with a three-month lag), has fallen for the second consecutive month.14 The index is down 16 points over the past three months. In the past 50 years, such declines led to a recession nine out of 12 times.15 I’m not predicting a recession, but it does suggest continued lackluster GDP growth, rather than acceleration.

While not all of the economic data are negative, I believe current investor optimism and equity market performance suggest much of the good news is already priced into stocks.

I believe equity market performance is likely to be determined by earnings growth and the price multiple investors are willing to pay. Since 1990, S&P 500 Index revenue growth rates have exceeded the nominal GDP rate by 1%, and earnings growth rates have exceeded revenue growth by 1%.16 Based on this past relationship, 2013 S&P 500 Index earnings growth should average 5% to 6%. At the end of January, the S&P 500 Index was already up 5%, so any further upside would have to come from better-than-expected economic growth (which seems unlikely for the reasons above), share buybacks and/or a higher earnings multiple. Further multiple expansion also seems unlikely, given the 67.5% correlation over the 10-year period ended Nov. 12, 2012, of S&P 500 Index price-earnings (PE) multiples and consumer sentiment, which is likely to continue its downward trajectory.17

On a risk-reward basis, as long as the year-over-year percentage change in LEI remains in a downward trend, I believe investors should continue to overweight high-quality, large-cap growth stocks with high or growing dividends. Improving growth in China is likely to benefit the commodity and material sectors.

Rising expectations for the beginning of a new secular bull market do not appear to be supported by current fundamentals or leading economic indicators, in my view, which makes the equity market vulnerable to downward surprises.

Europe: underweight

In stark contrast to the Fed’s balance sheet, the European Central Bank’s (ECB) balance sheet has shrunk to the lowest level in nearly a year.18 The contrasting policies by the two central banks have been responsible for recent euro strength, which threatens to undercut policymakers’ efforts to pull the region out of recession. The ECB predicts the European Union economy will contract 0.3% this year.19 The International Monetary Fund (IMF) cut its global growth forecast on Jan. 23 and projected a second year of contraction in the euro region.19

Both US equity corrections (declines of nearly 20%) since 2010 occurred when the Fed briefly failed to renew its first round of quantitative easing (QE) in 2010 and let QE2 expire in 2011.20 I hope the same directional outcome won’t befall the European equity markets.

The euro crisis is not over, but the region is in much better shape than it was a year ago. However, the social cost to the region can be seen in December’s 11.9% unemployment rate, the fifth monthly increase.19 The one silver lining, in my view, is that although a stronger currency cuts into corporate earnings, it improves consumers’ purchasing power and should shield them from higher energy costs.

Investors should continue to acquire “best of breed” European multinationals, taking advantage of what I believe are attractive dividend yields, which have exceeded 4% on average, based on the MSCI Euro Index as of Feb. 13, 2013.21

Japan: neutral weight

Recently, the Nikkei 225 Index traded at a four-year high after the yen traded at a two-and-a-half-year low on Feb. 1.22 The correlation between the Nikkei and yen/USD exchange rate, currently at 87% (from November 2011 to January 2013), is the highest in 24 years.23 The Nikkei recently surged 3.8% in one day after news the BOJ’s governor will step down on March 19, accelerating a leadership transition to those who support greater policy accommodation.24 Unlimited QE could begin much sooner than 2014. A weaker currency should help restore Japan’s export competitiveness and provide an upward earnings surprise.

However, there could be a dark side to a weaker currency. Over the past six months, oil prices are flat in euros, up 12.7% in dollars and up 33% in yen.25 Japan is currently experiencing an extreme increase in commodity inflation. Over the past 20 years, the four largest equity corrections came six months after an increase in the inflation rate.26 The risk-reward investing in Japan will decline if the yen continues to weaken, in my opinion.

Emerging markets: overweight

Emerging market equities — up 1.3% in January as measured by the MSCI Emerging Markets Index — trailed developed equity markets’ 5% gain, as measured by the MSCI World Index.27 The equity markets in Brazil, Russia, India and China (BRIC) were up 4.2% for the month as measured by the MSCI BRIC Large Cap Index.28

China’s GDP expanded in the fourth quarter for the first time in two years, up 7.9% (year over year). China’s industrial production rose 10.3% in December.27

India’s consumer price index (CPI) rose 10.56% (year over year) in December, which was higher than in the previous month.27 Inflation concerns are likely to keep interest rates on hold at the Reserve Bank of India, which could limit further market upside from current levels.

In Latin America, returns were led by Mexico (up 5.5% in January).27 Brazil continues to underperform global emerging markets on investor concerns of rising inflation from higher energy prices. Over time, Brazil, a major exporter to China, may benefit from better Chinese GDP growth.

Emerging market equities currently trade at a 17% discount to developed market equities, which I believe is attractive considering emerging markets’ higher economic and earnings growth.27 Yet, the asset class has enjoyed 20 straight weeks of inflows, at a rising pace.27 Unfortunately, the fund flow levels triggered a sell signal from Bank of America/Merrill Lynch analysts. According to the bank, since 2007, periods of rapid inflows have historically presaged four to six weeks of emerging market underperformance relative to developed markets.27

I believe global QE should continue to move capital into risk assets like emerging market equities, especially with Japan joining the fray. In my experience, excess liquidity has tended to take asset prices beyond fair value.

However, the developed markets’ attempts to weaken their currencies through QE threaten to drive inflation higher in the emerging markets as commodity prices rise. These episodes of currency friction within the developed markets tend to end badly for emerging market equities as emerging market central banks are forced to raise rates and restrict capital flows. We aren’t there yet, but I believe the risk will likely increase throughout the year.

Final thoughts

I’m still bullish on global equities for the long term because I believe the positives outweigh the negatives. But some perspective is in order. The S&P 500 Index is still in an uptrend, and continued accommodative monetary policy could limit market corrections. Dollar weakness may provide US companies a pricing advantage that could allow them to gain market share and grow earnings. Investors do not need to chase risk assets. Instead, they should focus on large-cap, dividend-paying/growing strategies, which should remain in demand for income-oriented investors. These assets may not be the best relative performers, but I believe the journey could be less volatile.

In Europe, a stronger currency resulting from further reductions in the ECB’s balance sheet could threaten current equity prices.

Japanese equities are likely to move higher followed by a painful correction unless the magnitude of QE becomes a game changer and offsets the negative equity market effects of rising inflation. Emerging market equities have had a great run over the past 90 days and are due for some profit taking and consolidation. This is one region that likely benefits from monetary accommodation. However, too much of a good thing tends to end badly for this asset class. History doesn’t repeat itself, but it often rhymes. Asset bubbles tend to last longer and go higher than fundamentals would predict. The good news is we aren’t there yet.

1 Source: Gluskin Sheff, Feb. 4, 2013

2 Source: Bloomberg L.P., Jan. 31, 2013, and Gluskin Sheff, Feb. 4, 2013

3 Source: Ned Davis Research, Inc., Feb. 4, 2013

4 Source: Renaissance Macro Research, Feb. 7, 2013

5 Source: Credit Suisse, Feb. 4, 2013

6 Source: Instinet, LLC, Jan. 29, 2013

7 Source: Raymond James & Associates, Inc., Jan. 22, 2013. The Dow Theory is based on Charles H. Dow’s idea that the industrial stocks’ average and transport stocks’ average are likely to rally in sync, as manufacturers producing more goods would need more shipping to deliver the goods to consumer market centers. If the two averages diverge, it could be a signal that change is forthcoming.

8 Source: Bloomberg L.P., Dec. 31, 2012

9 Source: Bloomberg L.P., Dec. 31, 2012

10 Source: Thomson Reuters Datastream, Dec. 31, 2012

11 Source: Bloomberg L.P., Jan. 31, 2013

12 Source: Gluskin Sheff, Jan. 18, 2013. The Empire State Manufacturing Survey, the Federal Reserve Bank of Philadelphia Business Outlook Survey and the Federal Reserve Bank of Richmond Survey of Manufacturing Activity are regional surveys of the health of the manufacturing sectors in the state of New York, the Third Federal Reserve District (eastern Pennsylvania, southern New Jersey and Delaware) and the Fifth Federal Reserve District (the District of Columbia, Maryland, North Carolina, South Carolina, Virginia and West Virginia), respectively.

13 Source: Bloomberg L.P., Feb. 1, 2013

14 Source: Bloomberg L.P., Jan. 31, 2013

15 Source: Gluskin Sheff, Jan. 21, 2013

16 Source: UBS, Jan. 3, 2013

17 Source: Thomson Reuters Datastream, Nov. 12, 2012. Price-earnings ratio is a common valuation metric for stocks that compares a stock’s share price to its per-share earnings. Correlation indicates the degree to which two variables move in tandem with one another.

18 Source: Bloomberg L.P., Feb. 1, 2013

19 Source: “Euro Crisis Seen Taking Social Toll With Record Jobless,” Bloomberg News, Jan. 29, 2013

20 Source: Gluskin Sheff, Feb. 5, 2013

21 Source: Bloomberg L.P., Feb. 13, 2013

22 Source: Bloomberg L.P., Feb. 8, 2013

23 Source: Gluskin Sheff, Jan. 18, 2013

24 Source: “Shirakawa Accelerates BOJ Exit as Abe Presses for Stimulus,” Bloomberg News, Feb. 6, 2013

25 Source: Wolfe Trahan & Co. and Bloomberg L.P., Feb. 5, 2013. Data as of Jan. 31, 2013.

26 Source: Wolfe Trahan & Co., Dec. 5, 2012

27 Source: Bank of America/Merrill Lynch, Feb. 1, 2013

28 Source: Bloomberg L.P., Jan. 31, 2013

Important information

The opinions referenced above are those of Richard Golod as of Feb. 13, 2013, and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of other Invesco investment professionals. The comments should not be construed as recommendations, but as an illustration of broader themes. Past performance is no guarantee of future results.

All investing involves risk including the risk of loss. Diversification does not eliminate this risk. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Small- and mid-cap stocks carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. Common stocks do not assure dividend payments. Dividends are paid only when declared by an issuer’s board of directors and the amount of any dividend may vary over time based on the business prospects of the company.

This material is for educational purposes only and does not contend to address the financial objectives, situation or specific needs of any individual investor. It is not a solicitation or an offer to buy or sell any security or investment product.


The Nikkei 225 Index (or Nikkei Index) is a price-weighted index measuring the top 225 blue chip companies on the Tokyo Stock Exchange and is commonly considered representative of Japan’s stock market. The MSCI World Index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of developed markets. The MSCI Europe Index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of the developed markets in Europe. The Shanghai Stock Exchange Composite Index measures the performance of all stocks (A and B shares) traded on the Shanghai Stock Exchange. The S&P 500® Index is an unmanaged index considered representative of the US stock market. The Dow Jones Industrial Average is a price-weighted index of the 30 largest, most widely held stocks traded on the New York Stock Exchange. The Conference Board Leading Economic Index (LEI) is an economic indicator used to forecast changes in the business cycle based on a composite of 10 underlying components (including data on employment, manufacturing, consumer expectations, stock prices, money supply and interest rates, among others). Coincident-to-lagging ratio is the ratio of The Conference Board’s coincident index to its lagging index. The Conference Board identifies three categories for economic indicators: leading (e.g., building permits), coincident (e.g., retail sales) and lagging (e.g., employment data). The ratio between the coincident and lagging indicators is considered a good measure of the direction of the economy. The Institute for Supply Management (ISM) Manufacturing Index is a commonly cited gauge of manufacturing conditions based on surveys of more than 300 manufacturing firms conducted by the Institute for Supply Management. The Citi Economic Surprise Index for the US measures how a variety of macro indicators “surprise” relative to expectations. The Thomson Reuters/University of Michigan Consumer Sentiment Index measures consumer confidence based on surveys of consumers’ expectations about the economy. The MSCI Euro Index is designed to measure the equity market performance of countries within the European Economic and Monetary Union. The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization index designed to measure equity market performance of emerging markets. The MSCI BRIC Large Cap Index is a free-float-adjusted market-capitalization-weighted index measuring the performance of large-cap stocks in Brazil, Russia, India and China. The Consumer Price Index (CPI) measures changes in the prices of a representative basket of goods and services.

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