Quarterly Market Update
Red Light & Green Light – or Shades of Both
During the second quarter of 2013, the broad financial markets posted positive returns but certainly the returns were well below the torrid pace of the previous quarter. All three major U.S. centric asset classes (large-, mid- and small-capitalization stocks) grew one to three percent while weakness remained in the international area as measured by the MSCI EAFE Index.
In previous issues of Quarterly Market Outlook, we have highlighted that the underlying strength for the equity markets has been provided by both worldwide monetary accommodation and improved corporate operating fundamentals. We continue to believe both of these factors provide support to the equity markets. On a relative basis, it is very likely that equity fundamentals will be the more important of the two factors during the coming twelve months.
Figure 1 – The pace of stock market returns slowed in second quarter but remained positive with the exception of the MSCI EAFE
One of the worst market performing moments of 2013 occurred following Chairman Bernanke’s June comments. No substantial new information was disclosed by his remarks, merely a confirmation of likely Federal Reserve (the Fed) action in the event economic conditions improved (low rate of asset purchases) or conditions worsened (higher rate of asset purchases). However, the market pundits coined a new phrase "taper". These are the same pundits who have given us phrases such as fiscal cliff (instead of fiscal policy considerations), catching a falling knife (buying securities as prices fall) and blood on the street (severe overall market price decline), among others. While there is nothing incorrect about the "alliteration," these headline quotations do tend to oversimplify events and conditions.
Since Chairman Bernanke’s speech, considerable news coverage has been devoted to when the taper begins, how much the taper will be, etc. While we are not making light of the seriousness associated with the consequences of monetary policy changes, an overwhelming observation remains. Investors are viewing events as red light (stop) or green light (go) and candidly, this is not a healthy method for investing one’s assets.
Connected with taper talk, we hear comments that one should not own high-yield securities. Again, a nice headline, but not a red light or green light question. There is a distinction between high-yielding stocks and stocks with solid yields. Stocks may have high current yields due to a variety of reasons (excessive dividend payout ratios, strong growth in dividend payments, etc.). A recent Dividend Screen analysis by Ned Davis reviewed these variables as they would be used in select dividend investment strategies and highlighted the differences in long term performance.
Figure 2 – When comparing stocks, earnings growth and dividend growth are more important than the actual yield.
The exact return calculations are not the point of the above table but the relative relationships are important. While investors have focused on "yield grab" during the first half of 2013, the important things to consider are earnings growth and dividend growth. Cash flow which creates the ability to increase dividends also plays an important role in stock performance over time.
The potential for a Fed shift toward a more neutral stance has been expected but the timing is one where consensus has not been consistent. Yes, in an environment of rising rates, the attractiveness of bonds as income generators improve relative to stocks. Yes, higher interest rates will impact select equity sectors more than others. However, if the policy shift occurs due to improved economic activity, it should be viewed as a positive that additional monetary policy is not required because the implication is that economic and business conditions are of sufficient strength to be self-sustaining.
Figure 3 – A comparison of price-to-earnings ratios and earnings-per-share across capitalizations and developed and emerging countries.
Reflecting the solid upward movement in equity prices since 2009, there has been a gradual increase in price-earnings multiples. While 2009 may have marked a green light condition, the recent slight uptick in the multiple relationships does not create a red light situation. We conclude the uptick is an acknowledgment of the continued forecast of favorable long-term earning environment.
As we move into the second half of 2013, taper talk, higher interest rates and the upcoming U.S. debt ceiling debate are likely to increase market volatility and negative equity commentary. These equity comments will likely be focused on industries most commonly defined as interest rate sensitive. However, it is our perception these events will be more than offset by continued moderate earnings growth and better than expected economic activity. At current valuation levels, most market indices remain within reasonable valuation bands. Our preference remains for U.S. centric companies but investment opportunities are developing across all major indices.
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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).