Bounce Back

Deja vu.

The above chart illustrates that we've been down this road multiple times over the past year, where stocks decline by a decent amount, but not enough to represent an official correction, only to bounce back relatively quickly. Sentiment never really got "washed out," although it did back off of overly optimistic levels. But there was not the sort of panic selling that traditionally makes for a correction that clears the way for the next substantial run higher.

Additionally, sector action hasn't indicated that market participants are overly concerned about the economy, despite the weak start to the year. The traditionally defensive sectors, excluding utilities, did not fare better than the cyclicals during the selloff. The defensive areas of the market would traditionally perform better than the more economically sensitive groups if economic growth was the major concern. The utilities sector did outperform, however, likely as an interest rate play. Bond yields have again fallen, but haven't rebounded along with equities, sending investors into the traditionally high-yielding utilities sector in a search for income. Investors need to be aware that their portfolio risk profile will change if they replace fixed income positions with equity positions.

We continue to believe that the year will end up a positive one for equities, but the possibility of a correction in the near term can't be ruled out.

Weather stymieing stocks?

Weather has impacted the economy, and the latest economic data has generally been much weaker than expected, but has largely been excused as a temporary phenomenon due the extreme winter weather seen throughout much of the country. We are in the camp that the weather has distorted the actual economic growth trend, and we believe that there is some pent-up demand that has developed that will be released over the next several months. For example, January retail sales ex-autos and gas fell 0.2%, but we believe as temperature warm up we'll see some of those put-off purchases being made.

Of course, not all of the weakness will be recovered—some purchases, such as those for seasonal clothing, or expenditures on travel or eating out, likely won't be made up—putting a bit of a permanent dent in first quarter growth. We can gain some perspective from the jobless claims numbers, that are largely unaffected by weather, as they have remained near the levels they were at the end of last year, indicating a continuing growing economy.

Obviously, housing can be impacted by severe weather and that appears to have occurred, with the National Association of Homebuilder Sentiment Index falling from 56 to 46 in February (a record drop in a single month); while January housing starts fell a startling 16%. But lumber orders have remained strong, indicating the housing market is in a temporary weather-related soft patch, rather than falling apart. Homebuyers generally don't change their minds about moving just because of the weather; they just delay the transaction. And with interest rates remaining low, there is the very real possibility of a spring surge in housing to come.

Fed discounts data, works on communication

The Federal Reserve has also noted the weather as having a substantial influence on recent job growth, and that weather would not deter its quantitative easing (QE) tapering program. The minutes released from the January meeting showed that some Federal Open Market Committee (FOMC) participants thought that preparing investors for a rate hike would be appropriate; although that didn't appear to be the dominant opinion. In fact, the FOMC discussed how to communicate to the market that rates will continue to be held near record lows even if the official unemployment rate reaches the Fed's 6.5% threshold.

The bottom line is that we don't believe rate hikes are in the cards for this year. The FOMC remains concerned about the long-term unemployed, as well as the low labor participation rate; while inflation remains below its target, allowing it the flexibility to hold rates lower for longer. Finally, in testimony before Congress, Fed Chairwoman Janet Yellen sounded a decidedly dovish tone.

Fortunately, the drama in Congress has died down as the debt deal and budget agreement took the two largest near-term crises off the table. Overall, policy risk has ebbed as a market-moving force, but given it's a midterm election year, political volatility is likely to heat up again toward the fall. There is also increasing scrutiny around the Affordable Care Act (ACA) and its impact on the economy; especially in light of the recent somewhat-damning report from the Congressional Budget Office on the impact on jobs of the ACA.

Europe's deflation worries

Turning to the international picture, we believe the eurozone's economic growth will continue to recover in 2014, as leading economic indicators, PMIs, and confidence continue to improve. Unlike 2013, the eurozone could add to global growth rather than subtract from it.

Unfortunately, the eurozone's recovery is not yet self-sustaining. Lingering after affects of the recession are evident, with lending still contracting, and prices of goods and services moderating to levels that have brought about concerns of deflation, or a broad-based decline in prices. The drop in prices in countries such as Greece is a natural outcome of their "internal devaluation," where economic adjustment is accomplished through a drop in prices within the country, rather than by a weaker currency. However, subdued prices have extended to stronger countries, with German wages less inflation falling in 2013; French core inflation increasing at a very modest 0.1% in January; and eurozone wholesale prices falling by 0.8% in December.

Pressure is increasing for the European Central Bank (ECB) to act, given that its balance sheet continues to contract, which is an effective tightening of monetary policy. The complex picture for inflation resulted in the ECB postponing action at the February meeting, but there are also complexities in terms of options for the ECB.

A door may have opened with recent comments from German central banker Jens Weidmann that he wouldn't "rule out" pausing or stopping the "sterilization" procedure of the ECB. The ECB purchased government bonds under the Securities Market Program (SMP) between 2010 and 2012, but unlike QE in the United States, the injection of liquidity is "sterilized" or taken back out of the system through the issuance of short-term debt. It appears as though the pressure to act is becoming strong enough for one of the strongest opponents of QE to consider what was previously considered unthinkable. It is unknown whether this could set a precedent for a broader bond purchase program in the future.

Without more aggressive measures by the ECB, we believe lending could have difficulty thawing until bank regulation and capital standards are finalized. This isn't expected until the second half of 2014 at the earliest, which could keep economic growth subdued. Additionally there is the risk that European parliamentary elections in May could reignite anti-euro sentiment. Despite the risks and the potential for volatility, we remain positive on European stocks, due to the prospects for economic and profit margin improvement.

Japanese stocks await clarity

Japan's economy could likely see-saw near term, with a sales tax hike in April likely to pull forward demand into the March quarter, then subsequently drop. Looking past this volatility, there are questions about the rise in inflation that the Bank of Japan (BoJ) is targeting and whether it will break the deflationary cycle or simply reduce consumers' purchasing power. Despite Prime Minister Abe's call to boost wages, they aren't keeping up with inflation. While some businesses are granting one-time bonuses, we believe Japan's businesses may delay making more lasting wage increases until they have better certainty on demand.

The BoJ recently extended and boosted the size of its program to lend to banks; but of the combined 21.5 trillion yen that had already been set aside under the facilities, less than 9 trillion yen has been tapped so far. Therefore, we don't expect a lending boost from this action; but it may be a signal that the BoJ is willing to take additional steps if warranted.

In the meantime, until the BoJ increases the size of its asset purchase program, the yen, and therefore Japanese stocks, could be range-bound.

China concerns grow

Investors are uncertain about the trend for economic growth in China; with the shift in the timing of the Lunar New Year and the hand of government distorting normal market functioning. In January, exports and new credit were strong, yet the Purchasing Managers Index (PMI) fell into contraction territory, and the yuan dropped the most since 2010 in February. Meanwhile, the threat of several trusts defaulting increased the chatter to a feverish pitch about a potential burst of the credit bubble.

We agree that the shadow banking system grew too rapidly in too short a time frame, resulting in the potential for misallocated funds and risk of future defaults. The Chinese government has increased regulation on the shadow banking system, which could moderate credit issuance, increase borrowing rates, and slow economic growth in 2014.

However, the government may look to take a measured approach to balance growth and reform. The record high new credit issuance in January is a strong start for 2014, even though it could be the peak for the year. Debt defaults may increase in coming months, but we believe the government has the resources to recapitalize banks, and would be reluctant to massively reduce credit that primarily goes to local governments and state-owned enterprises. If growth fell further, monetary policy has room to ease and infrastructure spending could be accelerated. We don't believe a hard landing, or rapid drop, in China's economic growth is likely in 2014.

We have several issues on our radar screen. In March, there is the possibility for reform details at the National People's Congress and Chinese banks will be issuing 2013 earnings reports. Recent moderation of property sales and prices, as well as funding concerns for developers could create volatility; although we don't expect a large scale burst of the property market.

Pessimism toward Chinese stocks reins, with mutual funds experiencing outflows in 30 of the last 38 months. Meanwhile, we believe reforms to China's economy could result in higher quality and more sustainable growth in the future. As investors gain confidence about the reforms as the year progresses, the valuation discounts for Chinese stocks could decrease. We believe Chinese stocks could outperform the emerging market (EM) universe as we discuss in Emerging Market Stocks: Stay or Go?, Why New Reforms Make Chinese Stocks Attractive and at www.schwab.com/oninternational.

So what?

US stocks have bounced and we think the market's still attractive and in the midst of a secular bull market. But there are likely to be bumps along the way; notably given that this is a midterm election year; which are known for first-half pullbacks. A diversified portfolio is important and both European and Chinese stocks appear to have upside, while Japan continues to frustrate with a two-steps forward, two-steps back sort of approach. And a final reminder not to replace fixed income assets with equities in search of higher income without recognizing the risk profile of a portfolio has changed.