Remarkable Resilience

Key Points

  • The strong uptrend in stocks has frustrated those waiting for a correction to get in. While there is certainly the possibility of a pullback, seen recently, investors should recognize that risk is a two-way street.
  • It appears that portions of the US economy are experiencing a soft patch, but we believe they will be relatively short-lived and other economic data point to modest growth. The Fed has increased talk of tapering purchases, causing some volatility, but we believe the bar is still relatively high and if bond buying is reduced, it would be a good sign.
  • Japan's economy appears to be improving although near-term risks have risen for the stock market. Europe continues to deal with a recession but policy shifts have the potential to help, while China continues to focus on structural economic and social changes rather than short-term stimulus.

Note: Due to the upcoming holiday, the next scheduled Schwab Market Perspective publication will be June 14, 2013.

The uptrend in stocks since November has been impressive…and frustrating to investors that have remained skeptical, or who have been waiting for a meaningful pullback to put money into equities. Unfortunately, some have had to learn again that risk is a two-way street (at least). Most focus on the downside risks of losing money due to a decline in prices, but there is a more stealth, but potentially more damaging upside risk. By staying on the sidelines during this most recent rally, investors would have missed out a roughly 15% year-to-date gain in the overall indices, while likely sitting in cash or low-yielding fixed income assets. There will be inevitable pullbacks, as seen recently, corrections, and outright bear markets, but over time, stocks have moved steadily higher, and investors who try to time the market, typically end up timing their losses.

Beware the upside risks

Source: FactSet, Standard & Poor's. As of May 20, 2013.

While it may seem like we're due for a correction, defined as a 10% pullback, as the most recent one based on the S&P 500 was in the middle of 2011, history doesn't tell us that it's inevitable in the near term. While there certainly will be a correction at some point, and it could be in the next couple of months, there still could be quite a bit of upside to go. In fact, our friends at Strategas Research Partners point out in their May 16 note that there were no 10% corrections during the stock market rallies between 1962-1966, 1984-1987, and 1990-1997. And while we're not predicting when the next downturn will come, trying to time it seems foolhardy to us. And for now the indicators we watch aren't flashing much of a warning signal. Professional investor sentiment is improved but not yet to levels that would indicate extreme optimism, based on Investors Intelligence Bull/Bear Ratio, although retail sentiment was elevated before the recent selling, valuations have gotten a bit richer but still appear reasonable to us, and there still aren't many attractive alternatives for money at this point in time. While we don't predict the future, we believe that the evidence suggests further gains, although likely not smooth sailing and not as sharp as we've seen in the first half of 2013, are likely.

Little change to economic story

The economic picture remains relatively supportive of continued gains in equities in our view, staying in that kind of sluggish growth spot that allows the Fed to stay ultra-accommodative while not nearing contraction territory. We continue to see signs of a minor soft spot, largely led by manufacturing, but we believe it will be relatively minor and that growth will accelerate toward the second half of the year. We've seen disappointing regional manufacturing surveys as the Empire Manufacturing Index fell to -1.4 from 3.1, while the Philly Fed Index dropped to -5.2 from 1.3, both indicating modest contraction in manufacturing activity. Additionally, industrial production disappointingly fell 0.5% in April after a gain of 0.3% in March. We aren't overly concerned yet, but are watching trends closely.

Helping us stay relatively optimistic, the American consumer continues to show resilience as April retail sales, excluding autos and gas, rose a nice 0.6%. Despite the headwinds of higher payroll taxes, consumers continue to spend, helped by lower gas prices and the boost to confidence that comes from rising net worth as home prices continue to move higher along with stocks—the two major components of most Americans assets.

Housing helping to bolster confidence, spending

Source: FactSet, Nat'l Assoc. of Realtors. As of May 20, 2013.

And housing continues to improve, although not in a straight line. The National Association of Homebuilders (NAHB) Survey showed sentiment improved to 44 from 41 in April, while building permits—a forward-looking indicator jumped 14.3%, although much of that gain was attributable to the volatile multi-family component. While tempering some of the optimism behind the permit number, the multi-family volatility also helps to mitigate the disappointment that might come from a surprising 16.5% drop in new home starts, but that's largely due to a 39% fall in multi-family starts.

We remain optimistic on the second half of the year due in part due to continued improvement in the housing market, but also due to the massive amount of cash on corporate balance sheets that we believe will increasingly be put to work. Already we've seen an increase in dividend payments and stock buybacks, both of which can enhance shareholder value, and we believe we'll see more capital expenditures as companies make up for lost time due to excessive caution seen over the past few years. And while still low, the National Federation of Independent Business reported improved small business confidence, with the best reading since October 2012.

To taper or not to taper, that is the question

With this somewhat mixed economic picture, questions continue to swirl as to when the Fed may start to pull back on their buying of Treasuries and mortgage-backed securities ($85 billion/month). The recent testimony of Chairman Bernanke and minutes from its most recent meeting added to the debate, with concerns arising that tapering may occur sooner than expected. We believe the reaction was a bit overdone as the Chairman noted that the Fed remains data dependent, meaning it won't move unless things look substantially improved, which would tend to be a good thing. Additionally, this would likely be the first step in a long and slow process to a more normal monetary stance, which could cause some volatility as we saw, but not push the market sustainably lower. The employment market still remains somewhat soft although signs of improvement have emerged, while inflation shows no signs of forcing their hand. In fact, despite the concern over the minutes release, the Committee's most recent statement leaned slightly more dovish, not exactly the sign of an imminent pullback of stimulus.

At some point, presumably, the process of normalization will begin. And while there may be some initial volatility, at this point we believe such a move would be as a result of improved economic momentum, which should limit the damage and allow stocks to move higher even in the face of a somewhat less accommodative Fed.

Japan's outgrows G7

Unlike the Federal Reserve, the Bank of Japan (BoJ) is in the very early stages of a massive asset purchase program, aiming to double the monetary base (currency in circulation and deposits at the central bank) from 2012 to 2014. Just like the Fed's QE, an aim of the BoJ's asset purchases is to encourage investors to move into riskier assets. The rise stock and property prices results in a wealth effect, which can improve confidence, spending, profits and jobs in a positive virtuous cycle.

Japan's monetary easing just starting

Source: FactSet, Bank of Japan. As of May 21, 2013.

While investors have focused on the yen, Japan's economy has also responded, growing at a better-than-expected annualized rate of 3.5% during the first quarter. Japan outgrew the rest of the G7 countries, with the next fastest posted by the United States, growing 2.5%, and Canada, expected to have increased 2.0%. Consumer spending was the main contributor to GDP in the first quarter, adding 2.3 percentage points to the annual figure.

"Abenomics" is the strategy of the new Prime Minister, Shinzo Abe, to turn around Japan. There are three "arrows" in Abe's strategy: fiscal stimulus, monetary stimulus and structural reform. A fiscal stimulus of 10.3 trillion yen was announced in January, equal to 2.2% of GDP, a new monetary easing campaign by the BoJ was unveiled on April 4, and some structural reforms have been announced but have yet to be implemented.

There are risks for Abe's strategy, as a weaker yen raises the price of imports such as energy and food. Additionally, Japan's government needs to provide a detailed plan for reducing its fiscal deficit in order to keep the confidence of the bond market, as well as implement unpopular structural reforms to sustain the economic recovery.

We believe stocks could benefit over a multi-year period if Abe's strategy continues to work, giving us the phrase "don't fight the BoJ," but the already dramatic moves in the yen and Japanese stocks are subject to sharp short-term reversals as seen recently. Additionally, because the decline in the yen (and resultant rise in the US dollar) can cut into returns, hedged investments have outperformed thus far, but this may become less important going forward if the yen stabilizes.

Ripples from Japan extend globally

The Bank of Japan's actions and changes in Japan's economy have global implications that affect all investors. The BoJ is planning on purchasing roughly $1.3 trillion over the next two years, and Japan is the world's third-largest economy. Therefore, what happens in Japan can have global implications, such as:

  • A revival in Japan's economy could raise global growth
  • A weak yen results in a stronger currency elsewhere, which can reduce the competitiveness for those that compete with Japan, such as Asian countries as well as German and US exporters
  • Increase global money supply and the hunt for yield
  • Boost the US dollar and lower commodity prices, as most commodities are priced in US dollars
  • Lower commodity prices and inflation outside of Japan increase consumer purchasing power, benefitting consumer-oriented countries such as the United States.

A better tomorrow for Europe?

Just a year ago, the elections and instability in Greece threatened to break apart the euro. Since that time, policymakers have demonstrated a strong commitment to the euro and the European Central Bank's Mario Draghi promised to do "whatever it takes" to preserve the euro. However, while the risks have receded and stocks have risen, the economic recession in the eurozone has continued, prompting the question of whether investors are being complacent.

We believe the forward-looking stock market is taking solace in the attitude shift of policymakers, which has gone from erecting walls to economic growth, to devising ways to boost the outlook in upcoming quarters, including:

  • The European Central Bank (ECB) cut the benchmark interest rate in May and is considering other non-standard measures.
  • The fiscal drag in 2013 will likely be less severe than in 2012. The biggest adjustments are in the rear view, and France and Spain were granted two more years to cut public deficits to below 3% of GDP.
  • Germany announced a plan to boost investment in smaller companies in Spain.
  • Germany and France are reportedly preparing a "New Deal for Europe," utilizing the European Investment Bank to unlock "billions of euros" in the form of loans to companies that create jobs for young people, according to a German newspaper.

Eurozone stocks have lagged

Source: FactSet, Standard & Poor's, MSCI. As of May 21, 2013.

Negative stories about the eurozone abound, but investors may want to consider the story less told, which is that progress, albeit slow, is being made. Meanwhile, earnings and valuations for eurozone stocks are still depressed in our view and a fair amount of bad news has likely already been priced in.

China sacrificing near-term growth

While developed countries are adding stimulus, the emerging market and second-largest global economy of China is doing the opposite. China's new leadership is on a campaign to reduce inequality and broaden wealth distribution, both for individuals and corporations, sacrificing near-term growth for reforms and structural rebalancing. China's economic growth has disappointed, and expectations appear still too high, as estimates continue to be cut.

Meanwhile, a large-scale fiscal stimulus by China's government does not appear likely at this point. On May 13, new Premier Li said that "the room to rely on stimulus policies or government direct investment is not big—we must rely on market mechanisms," and that relying on government-led investment for growth is "not only difficult to sustain but also creates new problems and risks." Additionally, several officials recently stressed that the forthcoming urbanization plan may be less capital and resource intensive and instead focus on boosting the quality of life in China.

We've been expressing our concern about the sustainability of China's debt-fueled, construction-led growth. While reduced reliance on construction would be a positive long-term development, we believe China-related investments will encounter difficulty until investors have confidence about where and how China's economy stabilizes. Read more in our article "Avoid China – Subprime-Like Bubble Brewing ", as well as related topics at

So what?

We saw how the prospect of a sooner pullback in purchases in bonds by the Fed rattled the market both in the US and globally, but the picture, to us, has not changed to any great degree. A very gradual pullback, not even going to zero, in quantitative easing due to an improved economic situation doesn't spell disaster to us. We continue to urge investors to pay attention to both sides of the risk equation when making decisions and to keep the longer-term perspective in mind. Short-term swings are inevitable, but should not be the basis for sound decision making.

© Charles Schwab

© Charles Schwab

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