New Highs Bring New Worries

Executive summary

The sustainability of the rallies in US and Japanese equities this year so far is looking uncertain amid slowing year-over-year earnings growth and mixed global economic signals. European and emerging market shares have traded lower year to date and seem likely to continue lagging in the near term. However, on balance, I remain optimistic about global equities, seeking yield opportunities and investments with an actively managed, more selective approach.

  • Overweight US. With ample liquidity provided by the Federal Reserve (the Fed), appealing valuations and subdued investor sentiment, US equities could potentially see further gains this year. Companies with dividend growth and/or high free cash flow continue to look attractive, particularly as interest rates have declined again.
  • Underweight Europe. Valuations seem expensive, and earnings growth may continue to stagnate. Recession is likely to continue for the remainder of the year. However, it’s hard to ignore the region’s attractive dividend yields.
  • Overweight Japan. The Bank of Japan’s (BOJ) aggressive new stimulus program and a weakening yen may provide a positive backdrop for Japanese equities.
  • Neutral to underweight emerging markets. Short-term weakness may persist, but I remain bullish on the long-term potential of emerging market equities.

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

Be opportunistic

Japan and the US continued to lead global equity markets in March, rising 4.1% and 3.6%, respectively, while emerging markets declined 1.9% and Europe fell 0.5% (as represented by the MSCI Japan Index, MSCI USA Index, MSCI Emerging Markets Index and MSCI Europe Index, respectively).1 For the first quarter, the pattern was similar: Emerging market equities underperformed those of the developed markets, led by Japan (10.7%) and the US (10.1%).1

The JPMorgan Global Manufacturing PMI (purchasing managers index) was up in March (to 51.2), led by China, the US and Japan. The index has risen five of the past six months, and has signaled expansion (that is, readings above 50) for three months.2 Improvements in output, new orders and employment gained momentum, while price pressures eased.2 While overall conditions look pretty good, the number of countries (breadth) showing improvement declined, which has been associated with recession and equity market weakness in the past.2 However, since 1998, if a recession was averted, equity markets tended to see strong rallies after a brief period of weakness.2

Mixed economic data have investors wondering if certain equity markets may have peaked for the year or may even be primed for a correction. This month’s commentary will address these concerns.

US: overweight

On a fundamental basis, there are plenty of reasons to believe the rally year to date could be ending for US stocks.

Economic growth can be slower in the summer months. Second-quarter consensus gross domestic product (GDP) growth is expected to be 1.6% — almost 50% below the first-quarter estimated GDP.3 Recent unemployment claims, Federal Reserve Bank regional manufacturing surveys (Empire State and Richmond) and housing data (mortgage applications) have been disappointing over the past month.4 Consumer confidence has also been declining, with the fiscal drag likely to affect consumers after the tax season.5 Global economic growth estimates have been reduced by the International Monetary Fund (IMF) and Organisation for Economic Cooperation and Development (OECD).6 If the dollar continues to strengthen, export growth and corporate earnings could come under pressure.

That said, economic growth alone does not determine stock market performance. There are three reasons the S&P 500 Index is likely to continue to move higher, in my opinion.

  1. Don't fight the Fed(s). I strongly believe the adage is applicable to equity markets’ recent performance. More appropriately, the adage should be plural. The BOJ’s latest quantitative easing (QE) program is almost twice that of the US in dollar amount and five times as large based on share of GDP.7 Japan’s program has the ability to buy bonds, real estate investment trusts (REITs) and exchange-traded funds (ETFs). Between the US and Japan, $155 billion per month will be injected into the marketplace, not to mention the QE program by the European Central Bank (ECB) and the economic stimulus taking place in the UK. The impact of this liquidity is likely to continue to drive interest rates lower. Reducing the cost of capital allows stocks to trade at higher valuations before they are considered overvalued. Japan’s policy is designed to weaken the yen versus the dollar. One way to ensure yen weakness is to use the liquidity to buy US assets — stocks and bonds.
  2. Stocks are not overvalued. The S&P 500 Index is currently trading at 15.7 times trailing 12-month earnings as of April 12, which is still below the 25-year average of 16.7 and lower than the high end of the trading range over the past three years (18.77).8 The dividend yield for the S&P 500 Index relative to the yield on 10-year Treasuries is at levels seen less than 1% of the time since 1983 (a three standard deviation event).9 Many investors are buying stocks for income. A strategy of buying the 10 highest-yielding stocks on the Dow Jones Industrial Average, known as “Dogs of the Dow,” was up 17% in the first quarter (as measured by the Dow Jones High Yield Select 10 Index) compared with a 10% return for the S&P 500 Index.10
  3. Sentiment is not euphoric. Several sentiment gauges I follow have been suggesting considerable underexposure to equities and increases in cash allocations across retail and Wall Street portfolio allocations.

Although past performance is no guarantee of future results, consider these historical scenarios as well:

  • 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.11
  • Since 1950, positive first-quarter returns resulted in positive performance for the year 95% of the time.12
  • Since 1962, the equity market traded higher 96% of the time when the spread between the S&P 500 Index’s earnings yield and the 10-year Treasury yield was more than 400 basis points. The current spread is 456 basis points.13
  • Since 2009, the S&P 500 Index has been 87% correlated to the size of the Fed’s balance sheet, which is expanding by $85 billion a month under the Fed’s current QE and “Operation Twist” programs.14

If you’re worried about the market, don’t buy the market. Find an actively managed fund focusing on stock picking or an ETF that has a valuation and/or quality screen. Take what the market is offering — namely, yield. Interest rates are declining again, making dividend-yielding stocks more attractive. Instead of focusing on the highest-yielding stocks, focus on the dividend growers or companies with rising free cash flow. The business cycle currently favors value companies over growth stocks. The value sector is dominated by financial names, which are looking better, in my opinion.

Europe: underweight and be selective

Until the global PMI index rises above 52, European earnings growth is likely to stagnate, in my opinion. The region will be mired in recession for the remainder of the year. Cyprus put a temporary scare into the equity markets, and Slovenia is the next country likely to need a bailout.

The ECB’s less-than-aggressive monetary easing relative to that of the US and Japan is likely to keep the euro stronger than economic growth would dictate. A strong euro relative to the yen and/or US dollar should hamper European corporate earnings growth.

The MSCI Europe Index is trading at 15.56 times earnings, or 0.1% below the S&P 500 Index.15 European stocks seem a little rich to me, considering Europe’s lower profit margins, recessionary environment and a long road to recovery. That said, I continue to believe investors should consider taking advantage of the region’s high-quality multinational companies whose dividend yield, at 4.13%, is double the average dividend yield in the US.16

Japan: overweight

Japan is all about liquidity. The new governor of the BOJ wasted no time initiating a very aggressive QE program. Japan’s $140 billion of bond, REIT and ETF purchases per month is nearly twice the dollar amount purchased by the US, and its share relative to GDP is five times as large.7

The magnitude of this was not lost on investors, who continued to drive the Nikkei 225 Index (Nikkei Index) higher despite disappointing auto sales, GDP growth and inflation figures.16 The Nikkei Index is trading at 27 times earnings, slightly above the 10-year average.17 Investors should keep in mind the depreciating currency could lead to strong earnings growth, lowering price-earnings (PE) multiples.18

The Nikkei Index has further upside potential as long as the yen continues to lose ground against the dollar and euro, in my opinion.

Emerging markets: neutral to underweight

Despite emerging markets’ recent underperformance relative to that of developed markets, I continue to be bullish on the long-term prospects for emerging markets, as I’ve been for the past year. I believe the economic growth rates, equity valuations and corporate balance sheets may generate potentially superior equity returns over the long term, especially when considering the gap between the size of their economies and the size (dollar amount) of their stocks markets.

The relative performance of the MSCI Emerging Markets Index to the S&P 500 Index has broken below its 200-day moving average, which, in the past 10 years, suggested further emerging market underperformance.19 Part of emerging markets’ recent lag can be attributed to the index’s higher exposure to commodity-related (materials and energy) companies and lower concentration in consumer sectors (health care, consumer discretionary and consumer staples) relative to developed-market sector weightings.20 Since 1995, when commodity-led sectors have underperformed consumer-led sectors — as has been the case lately — emerging market equities tended to underperform developed market equities.21

I have reduced my tactical overweight allocation to reflect emerging markets’ likely continued underperformance over the next quarter or two. Nevertheless, investors with a long-term time horizon and appropriate risk tolerance should continue to overweight this asset class, in my opinion, especially with an actively managed emerging market fund that is overweight the consumer sectors.

Final thoughts

The S&P 500 Index’s 11.42% year-to-date return as of April 12 is higher than the expected earnings growth rate for 2013, in my opinion.21 If the US equity market is going to continue to move higher, investors must be willing to pay a higher multiple for those earnings. Further declines in energy prices should increase disposable income. Upward momentum in housing prices should increase consumer sentiment. The expected improvement in employment and wages should increase consumer spending. These factors, together with continued QE from Japan and the US, should provide the fuel to move US equity prices higher, in my opinion.

On a global basis, the Japanese and US equity markets look the most attractive, given the magnitude of their central banks’ QE initiatives. Emerging markets and Europe are likely to continue to lag the other regions in performance. Investors should take what the market is providing — an attractive income stream. Overweight equities in markets with an aggressive monetary policy, overweight dividend-paying stocks and overweight large cap over small cap and value over growth.

Important information

The opinions referenced above are those of Richard Golod as of April 15, 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.

1 Source: Bank of America/Merrill Lynch, April 2, 2013

2 Source: Ned Davis Research Group, April 3, 2013

3 Source: Bloomberg L.P., April 15, 2013

4 Source: Bloomberg L.P., March 31, 2013, April 5, 2013, and April 30, 2013. The Empire State Manufacturing 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 and the Fifth Federal Reserve District (the District of Columbia, Maryland, North Carolina, South Carolina, Virginia and West Virginia), respectively.

5 Source: Bloomberg L.P., March 31, 2013. The Consumer Confidence Index is a commonly cited gauge of consumer sentiment about business conditions, employment and income, measured and published by the Conference Board.

6 Source: “IMF to Trim Global Growth Projection,” The Telegraph, April 14, 2013, and “OECD Slashes 2013 Growth Forecast,” Financial Times, Nov. 27, 2012

7 Source: Robert W. Baird & Co., April 4, 2013

8 Source: Bloomberg L.P., Jan. 9, 2013, April 12, 2013, and April 15, 2013. Trailing price-earnings ratio is a measure of a stock’s value calculated by dividing its current share price by its earnings per share over the previous 12 months.

9 Source: Invesco research, April 11, 2013. Standard deviation is a measure of how much a data sample varies from the average (e.g., its expected value). The larger the standard deviation, the farther the data is from its expected value.

10 Source: Bank of America/Merrill Lynch, March 27, 2013

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

12 Source: Bloomberg L.P., April 15, 2013

13 Source: Invesco research, March 29, 2013

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

15 Source: Bloomberg L.P., April 12, 2013

16 Source: “Central Banks Unleash Stimulus as BOJ Joins Easing Odyssey,” Bloomberg News, April 5, 2013

17 Source: Bloomberg L.P., April 12, 2013, and Invesco research

18 Price-earnings ratio is a common valuation metric for stocks that compares a stock’s share price to its per-share earnings.

19 Source: Thomson Reuters Datastream, April 12, 2013

20 Source: Ned Davis Research Group, April 2, 2013

21 Source: Bloomberg L.P., April 12, 2013


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The MSCI Japan Index measures the performance of Japan’s equity market. The MSCI USA Index measures the performance of the US equity market. The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization-weighted index designed to measure equity-market performance of emerging 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. JPMorgan Global PMI is a monthly measure of global business conditions based on surveys from the manufacturing and services sectors in more than 20 countries. The S&P 500® Index is an unmanaged index considered representative of the US stock market. The Dow Jones High Yield Select 10 Total Return Index measures the performance of the 10 stocks in the Dow Jones Industrial Average with the highest annual dividend yields. 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 Dow Jones Industrial Average is a price-weighted index of the 30 largest, most widely held stocks traded on the New York Stock Exchange. Earnings growth rate is the percentage gain in net income over time.

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