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Quarterly Market Update

Equity Outlook

Calm Prevails in Equity Markets

The stock rally continues but there appears to be an increasing degree of healthy skepticism about its sustainability.

Most equity asset classes advanced for the quarter and year-to-date, but perhaps the largest surprise was the extremely low volatility despite uneven economic results and sectarian violence in Iraq. Indeed, in June, the CBOE Volatility Index hit its lowest level since 2007. Some pundits attribute the calm to investor complacency given the Fed’s continued efforts to keep interest rates low. While the Fed is tapering at a steady $10 billion a month pace that began in December, it is still a net purchaser of U.S. government securities which continues to support the economy and equity markets.

Other pundits point to the dearth of more attractive investment opportunities. Investors are still looking for higher return possibilities whether in equities, the bond market, or real estate and that is a tall order given that most asset classes are reaching, or have reached, lofty prices from a historical perspective. Equities continue to be a place where investors can find returns and attractive dividend yields. Many investors have sat out the equity market rally of the past few years and continue to look for an entry point and opportunity to buy on a meaningful sell-off. Even modest pullbacks of the sort we saw in the second quarter only lasted a few days before inflows again commenced. However, there appears to still be some degree of healthy skepticism about the sustainability of the current rally and investors were net sellers of equity mutual funds for the quarter. According to the Investment Company Institute trade group, investors pulled a net $15.1 billion from U.S. stock mutual funds in the second quarter through June 25, a reversal from net inflows during the first quarter, although year-to-date flows remain positive.

Benefiting from relatively attractive dividend payouts, the U.S. REIT market was the quarter’s top performer followed by emerging market equities. The S&P 500 set 16 record closings during the quarter, returning 4.49%. Mid cap stocks returned almost four percent. The European Central Bank’s (ECB) commitment to ramp up monetary stimulus boosted developed equity markets. Small caps, which continue to be under pressure after outperforming the broader market in 2013, were the worst performing domestic market style. Investors took gains in small caps and dialed back their risk profile as the market continued to consolidate gains.

Money flowed into the economically sensitive areas of the market in anticipation of continuing economic improvement which led to the value investment style’s outperformance relative to the growth style.


Equity Chart 1

Figure 1. Broad equity market returns are positive year-to-date

Outlook

Earnings once again appear to be poised for a modest improvement over 2Q2013.

We anticipate modest domestic equity returns for the balance of the year as companies continue to deliver earnings growth that supports current valuations. Oft repeated concerns of an equity market bubble are unwarranted in our minds as both the U.S. and world economies continue to improve which should help companies to produce improved earnings for the balance of 2014. The S&P 500’s current PE on forward earnings of 15.6 sits just slightly below the 15-year average on the index of 15.8. Certainly not cheap by any stretch of the imagination, but a far cry from the bubble territory experienced during the dot.com craze of the late 1990’s. Although the U.S. economy continues to grow at a frustratingly slow pace, we experienced modest earnings growth in the first quarter and the stage appears to be set for even better earnings growth in the second quarter, which should be more than sufficient to support current prices. Companies have once again done a good job of setting low expectations for earnings this quarter. Indeed the stage is set for equities to continue to move up modestly for the balance of the year and while the upside is certainly not unlimited, current levels are not bloated, and we would view any pull-backs as an opportunity to add to current positions.

Historically equity markets have experienced a pullback when the Fed makes the first federal funds rate increase, but that is not expected to occur until the second half of 2015. Investors will also be watching how the markets respond to the conclusion of tapering forecast for October. The end of the Fed’s taper is likely to pose the biggest challenge to equity prices this year.

We continue to believe that emerging market equities have the greatest upside surprise potential based on our contention that expectations for this area of the market are so overly depressed as it has become the style to hate. In the search for reasonably priced companies, valuation metrics in emerging markets are much more attractive than many other parts of the equity market.


Equity Chart 2

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

Developed international markets also appear attractive as many did not experience the dramatic multiple expansion U.S. equities did last year. While not as undervalued as emerging markets, those markets are poised to produce attractive returns for the balance of 2014. Japan is doing well, and many of the Eurozone economies that were in recession such as Italy, Spain and the UK, are now in recovery. Add to that the ECB’s increasingly accommodative monetary policy and the potential for these markets look even more attractive. Although the ECB has been behind the curve in terms of action, it is ramping up its stimulus efforts just as the Federal Reserve in the U.S. is dialing its stimulus back. Using U.S. equity markets as a guide, even if European equity markets only respond modestly to their central bank’s intervention, the potential for improved returns in the Eurozone markets are greatly enhanced.

The potential for small caps to do better over the balance of the year may have improved as they lagged dramatically during the second quarter, delivering only a third of the S&P 500’s return. The significant underperformance for the quarter as well as for the year-to-date period has helped ease some of the concerns over lofty valuations in the small cap space.

Large cap, quality companies should do well as these companies are in great shape financially and higher quality should increase in significance as the Fed becomes less accommodative and eventually moves into normalizing interest rates. More investor portfolios will likely be allocated to the large-cap space for the implied safety it affords as larger, healthier companies with strong balance sheets and lower debt-to-equity ratios should better handle a rising interest rate environment which appears to be closer than many investors believed going into 2014.

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).