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BBVA Compass

Quarterly Market Update

Equity Outlook

Earnings Should Drive Equity Market Returns

Earnings should drive equity markets this year and volatility will likely pick up, but the stage is set for investors to have a pretty good experience return wise, certainly better than what we might expect in the fixed income space.

The roaring stock market paused for a breather this quarter and like a tedious cocktail party, weather appeared to be the main topic of conversation. After record-breaking equity market returns in 2013, investors taking the time to digest the experience in a healthy move to back fill and consolidate gains was not surprising. The S&P 500 has risen 181% since its bottom in early March, 2009 and all bull markets must eventually pause and regroup.

The roaring stock market paused for a breather this quarter and like a tedious cocktail party, weather appeared to be the main topic of conversation. After record-breaking equity market returns in 2013, investors taking the time to digest the experience in a healthy move to back fill and consolidate gains was not surprising. The S&P 500 has risen 181% since its bottom in early March, 2009 and all bull markets must eventually pause and regroup.

Severe and prolonged weather conditions stalled the economy early on and prompted a defensive rotation into value stocks which have become more attractive on the price-to-earnings spectrum after last year’s run up in growth stocks. There was some evidence of profit taking as investors took the opportunity to rebalance their portfolios. Investors took money off the table in last year’s high flying technology stocks as well as small-cap stocks, but most changes were at the margin.


Equity Chart 1

Figure 1. Broad equity market returns achieve double digits for the one- and five-year periods.

Outlook

The pressure is on earnings to bring in returns in the equity space after multiple expansion drove 2013’s rally.

Companies’ earnings are under scrutiny and must come through. Last year’s stock market advance was predicated on multiple expansion, but this year will be all about earnings. To build momentum, investors need to see earnings growth driven more by positive economic news than continued corporate cost-cutting or share buybacks. Particularly large revenue growth numbers will not be necessary to impact bottom lines and although modest, the U.S. economy is growing at a sufficient pace to keep corporate earnings rising. Companies have extremely lean balance sheets and have limited spending on hiring and capital expenditures to the extent that a modest improvement on top line revenue growth could produce a pretty good bang for the buck on the earnings front.

U.S. companies have put off expenditures they can no longer delay. What with less noise and interference coming out of Washington, business confidence is improving and companies should potentially be more confident about spending some of the cash upon which they have been sitting.

We anticipate greater market volatility relative to that experienced in the year just ended. Investors must digest the returns of last year in order to go forward and keep the equity bull market healthy. In something of a repeat of last year, we saw a rather short-lived pullback of about 6% in the S&P 500 in late January/ early February. Money is so vigilant for an opportunity to come off the sidelines that the dips are not lingering. While we anticipate greater market volatility in 2014 relative to the previous year, it should certainly be nowhere near the levels we experienced in the midst of 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 countries.


Equity Chart 3

Figure 3. Volatility has declined since the height of the financial crisis in 2008-2009.

International stocks could be 2014’s dark horse, first quarter performance notwithstanding. One equity market theme we anticipate playing out is that investors will be looking for opportunities that offer better value, and certainly international stock valuations are attractive. Without necessarily being a screaming buy, both developed and emerging market international stocks could surprise on the upside because expectations are so low.

Emerging market stocks have become the asset class that investors love to hate. But after being down 3.5% last year and down again this quarter, this could be a case of the baby and the bathwater. Certainly should the Fed raise interest rates, emerging markets could experience an outflow of funds as investors follow higher interest rates. Also, the divergence between countries is widening. The recent political crisis in Ukraine sharply impacted the Russian stock market, but scarcely moved South American markets. in contrast, signs that China’s economy is weakening to its slowest pace in a decade is being closely watched for global import. Most emerging market indices are heavily weighted to China, but an underweight to that country certainly improves the odds for emerging market indices.

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).