Potential Threats to Equity Rally

Fed Minutes Spark Declines

The S&P 500 fell for the first time in 2013 during the holiday-shortened week. Speculation that the Federal Reserve would pull back on its open-ended purchases of $85 billion per month in Treasuries and mortgages led to the mild declines. For the week, the S&P 500 declined 0.2%, while the Dow Jones Industrial Average rose 0.2%.

Minutes from the FOMC meeting on January 29-30 were released on Wednesday. The committee members’ increased concerns about the impact of ongoing asset purchases surprised market participants. Specifically, “several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability.”

The committee members’ concerns have sparked fears that the Fed could end its easing program earlier than expected. The market impact from the central bank’s various installments of unconventional monetary policy is well known. It remains uncertain whether investors see enough organic strength in the economy and in the corporate sector to stay committed to risk assets once this measure of support is withdrawn.

A number of important economic data points were released last week, ranging from housing and inflation to the manufacturing sector.

Housing starts dipped in January following a month in which the series hit a recovery high level of 973,000. The most recent figure was 890,000, an 8.5% decline that came in 24,000 under expectations. Still, the series is up nearly 24% from a year prior, reflecting the broad-based strength in the housing market in 2012. Most of the series’ weakness was attributable to the multi-family housing measure, which is notoriously volatile. Building permits, on the other hand, remained robust, and will likely generate momentum in the months ahead.

Underlying strength in the housing market was also seen in existing home sales, which came in at an annualized pace of 4.92 million in January. This represented a slight uptick from December’s reading of 4.90 million, supported by a continuation of depressed inventory. At 4.2 months, the level of housing supply is at its lowest level since 2005, and the actual number of homes for sale is the fewest in 14 years, according to Econoday.

Inflation data on Wednesday and Thursday showed an economy that continues to face little pricing pressure. Both the producer and consumer price indices remained muted in January, reaching 0.2% and 0.0%, respectively, at the headline levels. On a year-over-year basis, both measures remain below the Fed’s 2.0% target. There will likely be more pressure on the consumer gauge in February, as gasoline prices have persistently moved higher in the wake of Hurricane Sandy due to production issues at several major refineries.

One of the more disappointing reports of the week came in manufacturing, with a somewhat shocking decline in the Philadelphia Fed Business Survey. The series declined to -12.5, in spite of expectations for a 1.1 reading. New orders helped drive the index down, and sparked concern that next week’s report on the Institute of Supply Management’s manufacturing index may slip back into levels denoting economic contraction. The manufacturing sector remains in a fragile state following a period of weakness last fall and the effects of Hurricane Sandy in October.

Potential Threats To Equity Rally

Equity markets started a third consecutive year in rather impressive fashion, gaining more than 6% to date. With so much optimism in the investment community, it is always worth keeping an eye open for risks possibly overlooked.

By now, it is apparent that investors are increasing their exposure towards equities with arms wide open. Data from the Investment Company Institute (ICI) estimates $39 billion flowed into equity mutual funds this year through February 13. Following outflows of $153 billion in 2012, the sudden reversal has been impressive.

Investors have plenty of reasons to continue increasing their bullish view on equities. According to FactSet, the current 12-month forward P/E ratio is 13.3, below the 10-year average of 14.2.

Source: FactSet

As earnings season nears its finale, the fourth quarter results have generally been positive. FactSet reports that 72% of the 429 companies in the S&P 500 index beat consensus earnings estimates. However, this comes with the context that analysts had significantly lowered expectations on a regular basis coming into the start of the reporting season.

Despite a generally positive reporting season, equity markets began to slow this past week, with the S&P 500 shedding 0.2%. It was a small bump in the road, but quickly caused prognosticators to call for a mini-correction. There are a few potential reasons they might be right.

Some believe the record inflows to start 2013 are more a result of accelerated distributions rather than any new appetite for risk assets. Due to potential tax increases in 2013, many companies issued special dividends or paid accelerated bonuses to employees. This led to a spike in personal incomes in December, and much of that newfound cash made its way into the equity markets. This phenomenon brings into question whether early inflows into stocks are sustainable.

Of course, the upcoming sequester may be a more imminent threat for equity markets. Beginning in March, mandatory cuts will take effect across the federal landscape. The Congressional Budget Office believes the $85 billion in cuts would result in 750,000 job cuts by year-end. Other analysis shows the spending cuts could shave 50-70 bps off 2013 GDP. Legislators have continued public posturing leading up to the event, suggesting that the automatic cuts will take hold as scheduled. This presents another economic headwind for markets in addition the expired payroll tax cut.

Source: Washington Post

High earnings expectations for the second half of the year present another problem for equity investors. At the end of 2012, analysts expected earnings growth of 9.5% in 2013. Analysts have since revised their estimates lower and now expect 8.2% growth for the year. In order for the S&P 500 to achieve its earnings target, companies need to generate some combination of margin expansion and accelerating revenue growth. With corporate margins already at record highs and economic growth still depressed, both of these objectives will be difficult to achieve.

As discussed in the introduction, the potential for the Federal Reserve to pull current quantitative easing (QE) measures off the table looks like an increasing possibility. Many have questioned whether the economy even needed the additional stimulus at a time when growth was already creeping higher. While asset purchases do not appear to be at immediate risk, Federal Reserve officials are beginning to think about next steps. Markets have been flush with cash because of the Fed’s actions and any hint of a change in policy will introduce a new headwind for the markets.

Finally, European issues continue to linger in the background. While the ECB has washed away some immediate concerns with a flood of liquidity, many of the same structural issues of high debt levels and weak growth persist. Even stronger nations such as Germany saw GDP unexpectedly retrench into negative territory in Q4 (0.6% contraction). With potential negative catalysts such as the Italian elections on the horizon, there remains a multitude of potential risks to the market from the troubled continent.

Investors are quickly reconsidering the attractiveness of equities, and current valuations suggest the timing is appropriate. There will always be risks for investors to consider, including the impact of sequestration and the ongoing risks in Europe. However, taking selectively calculated risks has been the winning course of action in the current environment as the market continues to climb a “wall of worry.”

The Week Ahead

This week features a raft of important reports spanning several sectors of the economy. The standouts include the second estimate of fourth quarter GDP, the personal income & outlays report, as well as the ISM manufacturing index.

Much of the week’s dialogue will center on sequestration scheduled take effect at the end of the month. Consensus generally expects the automatic spending cuts to occur without modification from Congress, although the legislative body could pass measures subsequent to its enforcement to shape the nature of the cuts.

Central banks meeting this week include Israel and Hungary.

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