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Quarterly Market Update

Equity Outlook

Downward Bias Characterizes Third Quarter

Given all the skepticism and predictions of a bubble, the current bull market might possibly be one of the most hated in history.

Third quarter introduced a pronounced downward bias to the U.S. stock market that for three years has run unimpeded by a correction. Valuations came under renewed scrutiny, and volatility ticked up relative to the stock market’s previously rather stoic advance. Growing disparity between asset class performances was sharply evident as investors in the camp that the end of the Fed’s asset purchase program could negatively impact the economy assumed a risk-off posture. Investors sold small and mid-cap stocks in favor of tried and true, less risky, larger cap U.S. stocks.

In the Eurozone and emerging markets whose economies have lagged that of the U.S equities, the risk-off trade also prevailed and both the MSCI EAFE and MSCI Emerging Market Indices fell versus large-cap U.S. stocks.

The Dow Jones Industrial Average closed above 17,000 on July 3 and the S&P 500 hit the 2000 milestone on August 25, but September has historically been the most challenging month of the year for equities. By the second half of the month, geopolitical events including ongoing tensions between the Ukraine and Russia, U.S. military intervention in Iraq and Syria against the Islamic State militant group, and pro-democracy protests in Hong Kong wiped out much of the quarter’s previous gains. The broader S&P 500 Index was down for the month along with small-, mid- and large-cap stocks. Emerging markets were hardest hit, down -7.39% for September.

Despite finishing September in the red, the S&P 500 was up 1.13% for the quarter, its seventh sequential quarterly gain and the longest such stretch since the 14-quarter advance that ended in 1998. In contrast, small- and mid-cap stocks across all investment styles were down for the reporting period.

Nowhere was investors’ risk-off stance more evident than in the small cap space which experienced its second correction of the year. Price-to-earnings ratios (P/E) were certainly stretched by stellar performance in 2013 (the Russell 2000 Index was up 38.82%) and investors concerned about lofty valuations and future economic growth fled smaller companies. The asset class took it on the chin, down -6.05% for the month, -7.36% for the quarter, and -4.41% year-to-date. After leading for much of 2014, mid-cap stocks also pulled back, although the asset class managed to hang on to a single-digit, year-to-date gain of 6.86%.


Equity Chart 1

Figure 1. Broad equity markets post double-digit returns for the 1- and 5-year periods.

Growth Outshines Value

Growth outperformed value across all capitalizations in the Russell family of indices as concerns mounted about the impact of October’s projected conclusion of the Fed’s quantitative easing program. When the economy begins to accelerate during periods when the Fed is easing short-term interest rates, value companies tend to outperform. Growth companies generally outperform when economic activity moderates as investors have historically favored companies that can grow their earnings at a faster pace during such periods.

Earnings Surprise to the Upside

U.S. companies enjoyed a better-than- anticipated second-quarter earnings reporting season. (Third quarter earnings will not be available until after the BBVA Compass 4th Quarter Market Outlook is published.) Since the recession ended six years ago, many companies have cut costs and become more productive which allowed for continued earnings growth despite relatively flat sales, but in second quarter, top line sales figures experienced some growth. Additionally, more companies beat both revenue and earnings estimates. Going into the reporting season, expectations were for bottom-line earnings-per- share (EPS) growth to be around three to four percent, but actual growth ended up north of 10%, once the quarter was fully reported.

Volatility Picks Up

The U.S. stock market advance has been rather stoic, and some pick up in market volatility was to be expected. The quarter was certainly more volatile, particularly after the confluence of geopolitical events hit in the second half of September.

However, given the record highs reached by both the Dow and the S&P 500, volatility has by no means reached the precipitous levels experienced during the financial crisis.


Equity Chart 2

Figure 2. A comparison of price-to-earnings ratios and earnings-per-share across capitalizations and developed and emerging markets.

U.S. Dollar Diverges from the Euro and the Yen

The U.S. dollar rose more than 8% against the euro and the yen, buoyed by the widening gulf between the U.S. and Eurozone’s central bank monetary policies. Consumer price inflation in the Eurozone fell to 0.3% in September, and the central bank stepped up efforts to head off deflation with interest rate cuts and plans to purchase bundles of private debt. While the Fed is poised to begin increasing short-term interest rates by mid-2015, the European Central Bank (ECB) and Bank of Japan (BOJ) have signaled an intent to further loosen monetary policy in the face of persistently low inflation and soft economic growth. This has sparked an as-of-yet unrealized hope and anticipation of a Eurozone stock market rally driven by an asset purchase program similar to that executed by the Fed, which many credit with aiding the large advance in U.S. equity markets over the past several years.

Outlook

iven all the skepticism and predictions of a bubble, the current bull market might possibly be one of the most hated in history. Much of the negative sentiment has its roots in the market collapse of 2007 and 2008, the effects of which are still evident in today’s anemic economic recovery and growth rate. The severity of the market selloff, and the value that investors lost, remain emblazoned in their minds, and many have stayed out of the market, missing the 200% rise from the lows reached in March, 2009.

It is important to bear in mind that while the Dow or the S&P 500 have not had a correction in three years, age alone does not kill a bull market. There must be a negative exogenous event such as a recession or other economic trigger beyond the mere fact that the market has gone X number of months without a pullback. Certainly the possibility of a pullback cannot be ignored, and the longer the bull market runs, the greater the odds become for a correction.

What has moved the market forward this year, and what should continue to move it forward, is a good earnings environment. Valuations have not suddenly become more attractive, but nor are they frothy. Reasonable is the new cheap when applying the yardstick to P/E ratios and the recent market pullback should ultimately boost final quarter, 2014 returns.

Forward earnings guidance for the balance of 2014 is strong. We anticipate EPS to be up around 6% in third quarter and north of that in fourth quarter. The combination of earnings and revenue growth which we saw in second quarter should bode well for stocks. That said, we are mindful that the continued slowdown in Europe could impact earnings going forward as many larger U.S. companies receive a large percentage of revenue and profits from overseas.

The strengthening dollar is indicative of how strong the U.S. economy looks relative to the rest of the world. As the Fed raises interest rates at a time when much of the remainder of the world is easing, the divergence in monetary policy will drive investment activity to the U.S., offsetting some of the concerns about valuations and the strength of the economic recovery.

The quarter’s correction in small caps and the recent pullback in emerging markets offers a bit of value. Valuations in the small cap style are a bit more attractive, and we would not be surprised to see some money flow back into the space by year end. The situation is similar for emerging markets although there is concern regarding how the Fed’s pending interest rate increase will impact these markets. Some emerging market constituents are better prepared which is to be expected as this must be the best telegraphed interest-rate hiking cycle ever anticipated. But investors must be selective as some countries are more prepared than others, and emerging markets remain a space where active management is important.

The conclusion of the Fed’s taper could have some short-term economic impact on the U.S. economy despite being drawn out over 10 months, but we do not anticipate any significant impact over the longer-term. Due largely to the gradual weaning period, the bond market and the economy have taken the event in stride. The economy should continue to improve, justifying current valuations and providing sufficient expansion for value to outperform growth. On a final note, we remind our readers that we are long-term investors, and how important it is to maintain discipline with respect to asset allocation despite short-term gyrations in the markets.

BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).