A Tough Act to Follow
Growing confidence about a sustained improvement in U.S. economic growth and a host of better than expected first quarter profits supported a 1.5% rise in the S&P 500 for April. Year to date the S&P 500 has risen 7%. Among the developed countries’ stock markets in the world, only Copenhagen and Stockholm have outperformed the U.S. equities market. The Canadian, British, German and Japanese stock markets are up 3-5%. Within the so called BRIC groups, Brazil and China are down year to date, India is flat, and Russia is up thanks to firm oil prices.
Drilling down in the U.S. market, we find a growing divergence of performance within the market. While the S&P 500 is up 7% year to date, the small-cap and mid-cap stocks have soared 14.6% and 13.3% respectively. The latter two groups remain in a 10 year bull market. The Value Line index is up over 15%. Value stocks are up 8.8% year to date, while growth stocks have risen 5.3%. The leading sectors year to date have been industrials (+14.8%), consumer services (+13.9%) and financials (+12.5%).
Much of the U.S. market results for the year so far are consistent with a cyclical bull market which has been with us since March of last year. The genesis of the cyclical bull market was the stabilization of the financial stress of the second half of 2008 and its easing in the following months. As credit spreads narrowed during 2009, stock prices moved higher, helped by favorable liquidity conditions courtesy of the Federal Reserve. By the fourth quarter of 2009, the economy had recovered to the point where employment conditions were likely to strengthen in the months ahead. Moreover, investors began to discount the operating leverage benefits to earnings from past cost cutting and potential growth in revenues. More recently, improving news about the economy together with better than expected profits reports, combined with continuing favorable liquidity conditions, have propelled the stock market higher. Overall sentiment about the financial system, the economy and the stock market has turned much more positive over the past 12 months, witness a 75% increase in stock prices during this period. Going forward, the markets may be challenged by whether the currently more positive sentiment can either be sustained or further strengthened.
At this point, it is likely the Federal Reserve will remain on hold with short term rates remaining at current levels, which in the past year has supported the financial markets.
Nonetheless, signs of more aggressive risk taking are beginning to appear that reach beyond the general improvement in the risk environment during the past 12 months. Aggressive exploitation of the high yield market through a sharp increase in high yield bond offerings is one example. The enthusiasm for small and mid cap stocks, especially ones representing lower quality, after an already 10 year bull market is another example. While the exuberance in these market areas is not yet excessive, we believe that the continuation of a favorable liquidity environment could lead to excess. Some of the decline in concern about taking risk experienced in recent years is becoming manifest again.
Fundamentally speaking, the basic question is whether the world economy is headed toward reflation or deflation. So far, the U.S., among developed nations, has had more success than most countries in reflating growth through aggressive fiscal and monetary policies. The consequent future concern is that growth for 2010 might be as high as 4% vs. 3% expected currently. At 4% growth, employment growth would likely be stronger than now anticipated. As a result bond yields would rise producing increased volatility in both bond and stock markets. Many observers believe this is more likely in 2011 or 2012 than in 2010. Nonetheless, conditions leading to this outcome bear monitoring.
The deflation camp would argue that a variety of developments are supporting its view. The fiscal crisis of Greece is an example. Restrictions placed on any package of financial assistance will likely constrain growth. Moreover, Portugal and Spain are also on the ropes. Italy is always a question mark. But Spain, Europe’s fourth largest economy, with 20% unemployment remains an area of growing worry. Europe is displaying little in the way of economic recovery. The PIGS of southern Europe could act as a restraint on European recovery. Moreover, the U.S. is likely to raise taxes next year and place more regulations on the financial system. These actions may be headwinds for growth. Deleveraging of U.S. individuals balance sheets is still taking place. Personal budgets remain conservative compared to the earlier years of the past decade. China is a question as it attempts to sustain growth at a rate that will not produce rising inflation. The yuan will be revalued upward putting more pressure on the purchasing power of the U.S. consumer.
So the cyclical recovery of the U.S. economy should continue, but headwinds of deflationary factors lie ahead. While analysts have been busy raising earnings estimates in response to the economic and profits recovery, we suspect that attainment of these more bullish prognostications may be more challenging in the future than they have been during past months. Based upon the foregoing, growth may challenge value stocks in the months ahead. And bond yields could fall further rather than rise as the consensus expects. More portfolio diversification may be more appropriate than less in the quarter ahead. With yield spreads having tightened, the potential exists for at least some increase in volatility at some point ahead.
A. Marshall Acuff, Jr., CFA
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC