A More Expensive Market
North American equity markets have risen significantly during the first quarter of 2013. The largest stock indices in America reached new records within the month of April and has continued in May. The S&P500 index hit a record high of 1,626.03, and the Dow Jones Industrial Average reached a record of 15,056.67 yesterday.
At current levels, equities are much more expensive than they were last year, despite the markets having experienced the largest one week drop in roughly 10 months (in April). Stocks as a whole, are looking much closer to their fair and intrinsic values. It has been much more difficult to find value in equities over the past several months.
Japanese equity markets have also spiked, with the Nikkei index experiencing the largest increase in approximately 8 years.
However, commodity related equities as a group have performed contrary to conventional equities. While energy & agricultural producers have experienced their largest weekly drop in approximately 10 months, metal miners have declined with more severity. In particular, large and junior gold miners [GDX/GDXJ], which were already undervalued, have declined even further and dropped to their lowest level in approximately 4 years. The same has been true with silver producers and the base metal producers.
Bonds which have traditionally moved counter to equities, have continued to rise to new bubbling heights (though lately at a slower pace than equities). Yields have been pushed even lower, with the prices of most corporate bonds trading at significant premiums to their face/redemption values and call prices. 10 and 5 yr U.S. Treasury yields (government bonds) have seen staggering declines from levels of approximately 4.63% and 4.51% in April 2007, to their current levels around 1.74% and 0.71% respectively. German 10 yr Bunds have also declined, to approximately 1.19% (for comparison).
Companies have been taking advantage of the rise in both bond and equity prices. This has been seen across the board with the increase in secondary stock and new debt offerings, especially from trusts, REITS, utilities, and other traditional income yielding businesses.
Positive Economic Data, Stimulus, Investor Demand – Driving The Markets
There are a couple of factors that have affected the equity & bond markets.
A string of positive economic data released in the first quarter of the year, has been a major contributing factor behind the recent rally in U.S. equity markets. Manufacturing, housing, and unemployment numbers surprised economists and the markets. Earnings at U.S. corporations for 2012, which were reported in the first quarter of 2013, showed that they were larger than they had ever been over the past few decades relative to GDP. This and the recovering economic data aided investor confidence.
However, the constant driving force over the past few years has been the Federal Reserve’s on going (and open-ended) commitment of injecting cheap money into the economy, via quantitative easing (stimulus measures). The Fed’s intention has been to stimulate the economy until unemployment decreases. It is also their deliberate intention to increase the appetite for more risky assets that offer higher yields & returns, in order to keep markets stable. Quantitative easing has pushed long term rates lower (lower yields), which has in turn driven up the appetite for higher returns.
Low yields have encouraging investors to put money into riskier assets, in both equities and riskier bonds. The strong appetite for higher yield & income, has resulted in an abundance of secondary stock & bond offerings, at attractive prices and lower costs of debt to the issuing companies. Lower quality issues have experienced strong offerings and investor demand.
It is interesting that investors have been seeking safety in U.S. Treasuries as well as in equities. Traditionally, we would see inflows into equities at the same time as we would see outflows from bonds. However, the global economic landscape has likely contributed to this investment behavior. Japan’s record QE measures were announced in April, where the Bank of Japan intends to inject $1.4 trillion into the economy in less than two years. The long term economic problems in Europe (sovereign debt, no growth) have become more apparent than ever with the most recent events that took place in Cyprus (bailout and confiscation of wealth).
Commodity related assets have become more volatile with recent broad declines (due to slowing demand from China), and with gold’s plunge in price last month (April). These conditions have likely directed investors to find a safe haven in U.S. equities, Treasuries, and corporate bonds, all at the same time.
The casual and average investor has seen their portfolio values increase, and their stocks & funds rise. They have also been hearing news reports of markets reaching new record highs, and their advisers have likely been telling them what inaction (not investing new money) may be costing them (recent stock market returns). Over-enthusiasm is taking hold of the market. With renewed demand for riskier assets, and U.S. equity markets rising to new records, investor confidence has risen the most since the onset of the financial crisis of 2007/2008. This has drawn the casual and average investors back into equity markets, more than with other investments (bonds, Treasuries). Casual & average investors, who have held back their money during the past few years, have been pouring money into ETFs, mutual funds, as well as individual stocks, in fear of “missing the boat” on the market rally. As a result, ETFs saw the their biggest ever monthly inflows during the past few months! On April 16 2013, BlackRock Inc [BLK], the largest money manger by assets, reported first quarter results and saw $39.4 billion in inflows for Q1 2013. Total assets under management (AUM) reached a record of $3.936 trillion, up 7% from a year ago as investors poured money into the markets. BlackRock, who owns iShares, the world’s largest issuer of Exchange Traded Funds (ETFs), said iShares ETF products continued “capturing $26 billion in net new business, as we continued to see adoption of ETFs across both institutional and retail investors” and “Investors turned to iShares as a way to quickly and efficiently increase their exposure to equity markets” during the first three months of 2013.
Investment Outlook & Market Expectations
My 2012 market expectations & outlook last year was inaccurate. Given the pace of global economic deterioration at the beginning of 2012, and rising market enthusiasm, I thought we would have experienced a significant stock market downturn sometime between 2012 and Q2 2013. My expectation that a high level of investor enthusiasm would push equity prices higher did not occur within the last 14 months. Equities still remained below fair value on a broad basis. Therefore, even though economic conditions continued to deteriorate, there was still an adequate amount of value available. The size and health of corporate earnings being reported in 2012 continued to beat estimates, and had room for equities to continue rising, which fueled investor confidence.
In the short term, I expect stock markets to continue rising to new records, as valuations are not yet over-priced.
However, markets will likely remain volatile (and even more so for commodity related equities). Many individual equities will experience huge one day increases in price, with corporate earnings that beat estimates. But there will be just as many individual equities that will see large one day decreases, with earnings that miss investor expectations. Investors will over-react to any bit of news in either positive or negative directions. Wild, one day, price swings will be seen (Tesla Motors +16%, Zynga -9%, Nokia -13%, CGI +16%,etc) as corporate profits are reported.
I extend my previous outlook and expect a significant market downturn within the next 12-18 months, given the conditions I mentioned and the current pace of which influencing factors are unfolding.
Factors & Conditions Affecting Outlook
My investment outlook & expectation is not based on the fact that the Dow Jones Industrial Average [DJI] or S&P 500 [INX] stock markets have been hitting new highs. The fact that the markets have been reaching record levels themselves, is irrelevant. Though there are numerous factors which influence my outlook.
Several factors relate to the continued deterioration of the global economy and related political situations. The U.S. Sequester which took affect in Q1 2013, did not seem to worry investors in 2012 or the earlier part of this year. One reason it should start to be of concern to investors (sometime after Q1 2013), is that the budget cuts will actually be implemented. The broad based cuts will negatively impact several areas of the U.S. economy, particularly employment and growth. Those are the areas that investors have also grown more (overly) confident about over the past 12 months. In addition, the effectiveness of the Federal Reserve’s QE is reaching its limit (or has already been reached). There are few Fed tools left to stimulate the economy and keep the markets happy.
If the Fed’s stance on rate policy changes, investors will pull money out of the equities and the bubbling bond markets. Rising rates will also affect investors and businesses that use leverage. Many investors & businesses have taken larger positions in risky assets and riskier business endeavors. The notion of higher rates (not even the actual change in rates) will draw investors away from riskier assets as real returns decline (i.e. cost of borrowing increases vs yield/return). Increasing rates mean the current fixed income products (such as bonds) would give decreasing real returns as an environment becomes increasingly inflationary. At the same time, guaranteed investments such as term deposits, will start to look increasingly attractive (no risk). During the last Fed meeting, there was indication that the committee expects rate increases starting in 2015. However, that may change sooner than investors may think. The majority of investors, believe the the accommodative stance of the Fed is only determined by unemployment and inflation thresholds. But in the FOMC meeting minutes released on May 1, 2013, the Fed stated “In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”
Aside from the United States, the global economy has very real problems. Growth expectations are simply too high and rosy for the U.S., Europe, China, Brazil, etc. Disappointment will follow when reality eventually sets in. We have already seen a glimpse of disappointment, when China’s new government lowered expectations for Q1 economic growth (7.7% vs 8% street expectation) which caused a large one day tumble for global stocks. China’s ever increasing credit bubble may cause a hard landing for the Chinese economy, something many investors are still ignoring. Unemployment in the euro area (EA17) rose to a record 11.9% in Jan 2013 and shows no sign of stabilizing any time soon. Even in Britain, The Office for National Statistics recently said the unemployment rate rose to 7.9% for the three months ending in February 2013. Austerity measures across the Euro Zone only address debt levels and liquidity, not growth problems. With unemployment rising past dangerous levels, growth is a necessary but absent part of Europe’s solution. Six nations (U.S., U.K., Japan, Germany, Italy, France) out of the eight G8 countries (other two are Russia and Canada) have seen negative GDP economic growth in 2013, as demand slows. Japan’s record setting QE plans may also disappoint, if money does not move through the economy as expected. The U.S. stimulus measures to increase the money supply has been an example, which has lead the Fed to exhaust almost all of their options.
The other factors, relate to investor over-enthusiasm with both forward corporate earnings growth and the market itself. Corporate earnings for the full year and fourth quarter of 2012 were reported in Q1 of 2013. Investors began to expect a continuation of increasing growth and record results. But not all Q4 2012 earnings were great. Some high profile companies had struggled, including Best Buy [BBY], Dell [DELL], and J.C.Penny [JCP], among others. There will still be good earnings and growth coming from individual companies going forward, but there will likely be larger contrasts between the stronger and weaker companies. On a broad basis, it will be very difficult for corporations to continue growing their earnings at the same rate or at an increased pace. Without large increases to demand domestically and/or globally (exports), earnings will begin to stagnate and disappoint investors. Even the once infallible Apple [AAPL], has recently lost some investor confidence. Apple’s Q1 2013 results saw record revenues, but a decline in profits. Investors took the stock lower (-19% year to date) as the company issued its lowest growth outlook ever.
The level of investor over-enthusiasm that had been absent during 2012 is present today in 2013. Analysts, banks, and investment firms, have started to announce increasingly higher & higher year end “guidance” and price “target” levels for the S&P500 and Dow Jones. This enthusiasm has caused the market price (market valuation) of equities to increase at a significant rate, compared to their intrinsic values and fair price. Yet, investors continue to purchase at higher and higher levels, with increased expectations. They are ignoring growth limitations, valuations, and the risks that lie ahead.
In the upcoming article, I will give an update on different investment strategies and discuss various opportunities, based on the expectations outlined here. As function-centric and value investors, market trends DO NOT form the basis for our investment decisions. However, knowledge of market conditions and our expected outlook of them, can be useful for determining the likelihood of upcoming conditions that may create opportunities.
DISCLOSURE: I do not hold or plan to initiate a position, in any of the above mentioned stocks, U.S. Treasuries, or index funds (that track the S&P500, DJIA, Nikkei, or gold miner indices), within the next 9 trading days.
Thanks & Happy Investing! — The Investment Blogger © 2013