Still Bullish

Executive summary

Global equities (as measured by the MSCI All Country World Index) fell modestly in February amid reignited fears about the euro’s future, signs of distress in China’s economy and the looming sequester deadline in the US.1 Nevertheless, I believe the US, Japan and emerging markets may offer compelling opportunities, while Europe requires a more selective approach.

  • US. Mixed economic data and the ongoing rally have some investors nervous. However, I believe the probability of continued gains and positive equity returns for the year has increased.
  • Europe. Current valuation and risk levels in European equity markets seem appropriate, given the uncertainties about the implementation of austerity measures and the economic outlook for the region. Investment opportunities lie in individual stocks, in my opinion, with multinational, dividend-paying European stocks looking attractive on a risk-reward basis.
  • Japan. With support from the Group of 20 (G-20) nations and a new governor at the helm of the Bank of Japan (BOJ), the yen looks likely to continue to weaken, which should bode well for Japanese equities.
  • Emerging markets. Disappointing data from China has weighed on emerging market equities lately, and the asset class could see further weakness in the short run. However, I believe patience is warranted.

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

Continue seeking equity income

Global equities (as measured by the MSCI All Country World Index) were down slightly in February as investors worried about the withdrawal of quantitative easing and tighter fiscal policy in the US; slower growth and curbs on the real estate sector in China; and the rising populist movement in Italy, which potentially threatens further austerity measures in Europe.1

Despite lack of resolution of these investor concerns, I believe the probability of positive US equity returns for 2013 has improved, if history is any guide. Japan’s equity market is likely to continue to move higher, and emerging market underperformance is likely to be temporary, in my view. However, I am less encouraged by the prospects for equity returns in Europe.

US: overweight

On the surface, economic data in the US appear to be improving. Yet skeptics claim the data are flawed, painting a more ominous outlook for the economy.

For instance, the 437,000 unit month-over-month increase in new home sales was on a seasonally adjusted basis.2 The actual number (not seasonally adjusted) was up only 31,000 units, which was only incrementally better than the month before.2 Therefore, only by using the most aggressive seasonally adjusted factors could someone have come up with a 16% increase.2 Skeptics also point out that sales prices on new homes are declining.3 Finally, the National Association of Home Builders/Wells Fargo Housing Market Index stalled in December and declined in January, suggesting growth in the housing market may have peaked.4

The skeptics also argue the recent upward trend in the PMI (Purchasing Managers Index) doesn’t square with either the Philadelphia Fed Business Outlook Survey (a regional measure of the manufacturing sector) or the Chicago Fed National Activity Index (a gauge of national economic health), both of which declined the past two months.5 The year-over-year percentage change in the Conference Board’s Modified Leading Economic Index (MLEI) has declined two of the past three months.6 The year-over-year percentage change in GDP growth has been 94% correlated to MLEI over the past five years.6

On the recent positive unemployment claims figures, skeptics mention the level of hiring has increased possibly to avoid paying the added cost of President Barack Obama’s health care reform package under the Affordable Care Act.7 If employers hire more employees but cut each worker’s hours below 40 hours per week, companies get the coverage without having to pay added health care costs.

The skeptics also make the argument that the 50-cent increase in gas prices since November, the 1.5% fiscal drag and the 0.3% sequester drag on GDP have yet to be reflected in economic data.8

This debate could go on and on. The data may be flawed, but I believe the indicators over the past month suggest the US economy is on more solid ground. Consumer confidence is improving, rightly or wrongly.9 I’m encouraged by the spike in new orders, which suggests demand is improving.10 The improvement in the new orders/inventory ratio is also welcomed.11

That said, economic growth does not always determine stock market performance. But if history is any guide, I believe the odds of positive US equity returns in 2013 have improved.

According to an analysis by Sam Stovall, chief equity strategist at Standard & Poor’s, since 1945, when equity returns (as measured by the S&P 500 Index) were positive in January and February, the equity market generated positive returns for the year 100% of the time.12

Over the past 50 years, the S&P 500 Index has historically generated its highest returns when the PMI rose above 50 to peak.13 The PMI has increased three consecutive months, moving from a level below 50 and now standing at 54.2.14

When Wall Street allocation to equities is less than 50% (currently 47%), stocks have traded positively the following year 100% of the time.15This metric, the Bank of America/Merrill Lynch Sell-Side Indicator, has been around for at least 15 years and has been back tested much longer.

More importantly, since 2009, the S&P 500 Index has been 87% correlated to the size of the Federal Reserve’s (the Fed) balance sheet, which is expanding by $85 billion a month.16

Another encouraging sign the market could potentially move higher, in my view, is the recent positive performance in the financial sector (as measured by the S&P 500 Financial Sector Index).17 I have felt for some time that the S&P 500 Index can’t continue to move higher without participation from the financial sector because of the sector’s large representation in the index.

Despite mixed economic data, the fundamentals that drive equity prices appear well anchored in what I think will be 5% to 6% earnings per share growth — with share buybacks potentially adding another 2% to 3% because earnings per share increase with fewer shares available — and a forward price-earnings (PE) multiple that has been constrained between 10.2 and 14.5 because of fear.18 As investors become less fearful, the PE multiple is likely to add additional upside to the equity market.

The risk-on trade — that is, one that strongly favors riskier assets — may continue to have its moments of outperformance, but low economic growth is likely to lead to more frequent spikes in volatility, which could move capital back into large-cap, high-quality, dividend-paying companies. Furthermore, given the backdrop of low interest rates, income-generating equities continue to look attractive. The highest-yielding stocks currently appear richly valued. I expect investors to broaden their definition of dividend-paying/growing companies to include companies with high free-cash flow.

Europe: underweight

In Europe, there are two competing forces: austerity and reforms versus increasing social unrest and the rise of populist movements. Nowhere is that friction more evident than in Italy. Last month’s elections resulted in a hung parliament and a populist vote against austerity in the third-largest European country. This threatens the European region’s solution to the sovereign debt crisis. As a result, investors were net sellers of European equities last month.19

In addition to increased political uncertainty, German economic data disappointed. Germany’s industrial production stagnated, and factory orders unexpectedly declined 1.9% in January as the recession in Europe dampened demand.20 As a result, the ECB lowered its growth prospects for the 17-nation eurozone economy to -0.5% for this year.20

I believe the European economy will likely be in recession throughout 2013. In the region’s equity markets, current valuations and risk levels appear appropriate. However, investment opportunities remain. Investors should consider focusing on multinational companies that are building market share in emerging markets. European companies currently offer some of the highest dividend-yielding stocks in the world.21 I believe these companies may offer a great risk-reward opportunity.

Japan: neutral weight

The G-20 nations gave Japan a pass at last month’s meeting in Russia. Instead of denouncing Japan’s aggressive depreciation of its currency, which could potentially disrupt global trade and create a currency war, the G-20 looked the other way.

The G-20’s statement and the selection of Haruhiko Kuroda as the next governor of the BOJ were seen as positive for Japanese equities. Kuroda, the ex-head of the Asian Development Bank, has said he will do whatever is necessary to end the 15 years of deflation. The yen/dollar exchange rate has declined 14.2% since November 2012.22 The Nikkei 225 Index has advanced for seven consecutive months.23

Emerging markets: overweight

Emerging market equities (as represented by the MSCI Emerging Markets Index) have recently underperformed the S&P 500 Index, mostly due to disappointing data out of China.24

China’s retail sales and industrial output for the beginning of the year were back to 2009 levels.25 Retail sales growth in the first two months of the year was up 12.3% and industrial production grew 9.9%, both below consensus estimates.25 Purchasing managers indexes in manufacturing and services missed targets as well.26 However, I believe China’s disappointing domestic demand data in February probably had more to do with the lunar new year holiday than a trend of lower economic growth. Along with disappointing economic data, the government announced additional measures to cool real estate prices. As a result, the largest companies on the Shanghai and Shenzhen stock exchanges, as represented by the CSI 300 Index, declined 4.6%, the most in two years.27

However, February export data out of China exceeded forecasts, indicating global demand could help support future economic growth in the world’s second-largest economy.28

I believe current valuations and gross domestic product growth rates suggest using equity market weakness as a buying opportunity. That doesn’t mean emerging market equity performance will turn around over the next couple of months. Emerging market performance relative to the S&P 500 Index just broke below the 200-day moving average, suggesting further weakness is likely.24

Final thoughts

I believe the US economy is improving — just not to the extent that the equity market is pricing in. That said, liquidity tends to take asset prices beyond fair value, and I wouldn’t “fight the Fed,” as the saying goes. This and the S&P 500 Index’s historically high correlations to unemployment claims and the Fed’s balance sheet suggest the equity market is potentially capable of higher levels.

Quantitative easing from the US, Europe and Japan — which have all pledged to do whatever is necessary — could limit equity market corrections. However, low growth in the developed world increases the risk of more frequent spikes in equity market volatility. Investors seeking more consistent returns should continue to focus on large-cap companies with quality balance sheets that generate dividend income streams.

Opportunities in Europe are on an individual stock basis. Economic growth in the region is likely to get worse before it gets better. Japanese equities continue to look appealing as long as the yen continues to depreciate — and it should, considering it has the blessings of the world’s largest central banks. Be patient with emerging market equities.

Important information

The opinions referenced above are those of Richard Golod as of March 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 MSCI All Country World Index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of developed and emerging markets. The National Association of Home Builders/Wells Fargo Housing Market Index measures home builders’ sentiment about the sales conditions for single-family homes, based on surveys conducted by the National Association of Home Builders. PMI (formerly Purchasing Managers Index) is a commonly cited indicator of the manufacturing sector’s economic health calculated by the Institute of Supply Management. Modified LEI measures the Conference Board Leading Economic Index (LEI) without money supply and the yield curve factored in. LEI is an economic indicator based on a composite of 10 underlying components (including data on employment, manufacturing, consumer expectations, stock prices, money supply, interest rates and others) used to forecast changes in the business cycle, calculated by The Conference Board. The S&P 500® Index is an unmanaged index considered representative of the US stock market. The S&P 500® Financial Sector Index is an unmanaged index considered representative of the financial sector of the US stock market. 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 Emerging Markets Index is a free-float-adjusted market-capitalization index designed to measure equity market performance of emerging markets. The CSI 300 Index is a capitalization-weighted index designed to measure the performance of 300 A-share stocks listed on the Shanghai and Shenzhen stock exchanges. The MSCI Euro Index is designed to measure the equity market performance of countries within the European Economic and Monetary Union. An investment cannot be made in an index.

1 Source: Bank of America/Merrill Lynch, March 1, 2013

2 Source: Gluskin Sheff, Feb. 27, 2013

3 Source: Gluskin Sheff, Feb. 27, 2013

4 Source: Bloomberg L.P., Feb. 28, 2013

5 Source: Bloomberg L.P., Feb. 28, 2013

6 Source: Thomson Reuters Datastream, Jan. 8, 2013

7 Source: Thomson Reuters Datastream, Jan. 8, 2013

8 Sources: Bloomberg L.P., March 11, 2013; Gluskin Sheff, March 5, 2013; Renaissance Macro Research, Feb. 25, 2013

9 Source: Bloomberg L.P., Feb. 28, 2013

10 Source: Bloomberg L.P., Feb. 28, 2013

11 Source: Thomson Reuters Datastream, Feb. 28, 2013

12 Source: Bloomberg News, “US Stocks Advance on Economic Data as Euro, Pound Drop,” March 1, 2013

13 Source: Wolfe Trahan & Co., Dec. 8, 2011

14 Source: Bloomberg L.P., Feb. 28, 2013

15 Source: Bank of America/Merrill Lynch, March 1, 2013

16 Source: Gluskin Sheff, March 8, 2013. Correlation measures the degree to which two variables move in tandem with each other.

17 Source: Bloomberg L.P., March 11, 2013. Performance measured from Nov. 14, 2012.

18 Source: UBS, Jan. 3, 2013. Forward price-earnings (PE) ratio is one measure of the price-earnings ratio that uses forecasted earnings (usually for the next 12 months or the next full fiscal year), rather than current earnings, for the calculation.

19 Source: Bloomberg L.P., Feb. 28, 2013

20 Source: Bloomberg News, “German Industrial Production Unexpectedly Stagnates,” March 8, 2013

22 Source: Bloomberg L.P., March 13, 2013. European, Japanese, US and emerging market stocks are represented by the MSCI Euro Index (4.03% dividend yield), Nikkei 225 Index (1.66%), S&P 500 Index (2.12%) and MSCI Emerging Markets Index (2.67%), respectively.

22 Source: Bloomberg L.P., Feb. 28, 2013

23 Source: Bloomberg L.P., Feb. 28, 2013

24 Source: Thomson Reuters Datastream, Feb. 28, 2013

25 Source: Bloomberg News, “China’s Retail-Industrial Data Show Weakest Start Since 2009,” March 9, 2013

26 Sources: Bloomberg News, “China Property Shares Drag CSI 300 Down Most in 2 Years on Curbs,” March 4, 2013; “China Export Surge Helps New Leaders Sustain Rebound,” March 8, 2013

27 Source: Bloomberg News, “China Property Shares Drag CSI 300 Down Most in 2 Years on Curbs,” March 4, 2013

28 Source: Bloomberg News, “China Export Surge Helps New Leaders Sustain Rebound,” March 8, 2013

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