Europe Is Near Term Driver of Market Movements
By John Buckingham
June 12, 2012
Equities Soar, Treasuries Plunge
Though the dates do not coincide, as there is a lag in the Investment Company Institute data, last week’s rally in stocks was accompanied by word that for the first time in seemingly forever, mutual fund investors actually put more money into domestic equity funds than they took out, while the reverse was true for bond funds. Indeed, for the week ended May 30, a net $807 million flowed into U.S. stock funds, compared to a $7.2 billion net outflow in the week prior, while a combined net $317 million was redeemed from taxable and municipal bond funds, versus an inflow of $2.8 billion in the preceding week.
Because it is only one week and Memorial Day was part of those ICI numbers, we hesitate to say that the tide is finally turning in terms of investor sentiment. In fact, our friends at the American Association of Individual Investors (AAII) remain very pessimistic on the prospects for stocks over the next six months as for the week ended June 6, only 27.5% of respondents were Bullish compared to 45.8% who were Bearish.
Also, Mark Hulbert’s Nasdaq Newsletter Sentiment Index (HNNSI), which reflects the average recommended equity exposure level among those stock market timers tracked by the Hulbert Financial Digest who focus on the Nasdaq market in particular, hit its most bearish reading (minus 47.1%) since early September 2010 on June 1. Illustrating the difficulties of market timing, these newsletter writers were heading into last week with nearly half of their portfolios shorting the Nasdaq market, only to be caught leaning the wrong way when the Nasdaq Composite index climbed 4% over the ensuing week. Believe it or not, Mr. Hulbert writes that the last time the HNNSI was this low was back in September 2010 when the Nasdaq Composite index was 2209. Three months later, the Nasdaq was nearly 18% higher!
No doubt, there are those who have successfully timed the market, but as Peter Lynch has said, the only problem with market timing is getting the timing right. Last week was a perfect example as virtually no one, including yours truly, was expecting the big upward bounce. The New York Times on June 1 cited a prominent analyst who said, “People are very risk-averse right now. What it tells you is investors are anxious and are willing to forgo a lot of potential return for the ability to park their money with what they perceive to be high quality, safe governments.”
The Wall Street Journal summed up well the mood of investors in last Monday’s edition:
“Investors across financial markets have reacted with increasing alarm at the drumbeat of bad news from all corners of the world, with economies sputtering just as troubles in Europe flare anew. Concerns that Greece may be forced to exit the euro zone have joined worries that Spain may also collapse under the pressure of a high deficit and fragile banking system…Potential market land mines dot the horizon. Greece holds new elections June 17 that will largely determine its course. The Federal Reserve's rate-setting committee, scheduled for June 19 and 20, could signal leanings toward further stimulus. And on June 28 and 29, a summit of European Union leaders in Brussels will be closely watched by investors for evidence that policy makers will increase efforts to solve the region's crisis.”
Of course, we did comment on last week’s missive that the fear/greed pendulum had swung pretty far in the direction of the pessimists and we noted that when so many folks are convinced that the market is heading in one direction, it often pays to be a contrarian. There is certainly no guarantee that the rebound will be long-lasting, despite the big rally in the equity futures on Sunday night, but it is also important to remember that these days central bankers and government officials are doing all that they can to boost their economies, as evidenced by this weekend’s announcement that Spain secured a 100 billion euro ($125 billion) loan to bolster its banking system. We also saw China last week make a surprise cut to interest rates, with more cuts possible, especially given this weekend’s benign inflation data out of the Middle Kingdom. And though the European Central Bank did not cut interest rates last week from the current 1.0% level, its president Mario Draghi reminded all, “We will stand ready to act.”
Here at home, some thought Federal Reserve action was imminent after Janet Yellen, vice chairwoman of the Federal Reserve Bank, commented, “I am convinced that scope remains for the [Fed] to provide further policy accommodation.” Fed Chairman Ben Bernanke suggested otherwise, when he told the Congressional Joint Economic Committee, “Economic growth appears poised to continue at a moderate pace over coming quarters,” a position supported by the relatively upbeat tone to the Fed’s latest Beige Book.
The economic statistics out last week were also keeping with the view that the economy is growing at a moderate pace. The Labor Department said that first-time claims for unemployment benefits reversed four weeks of increases, declining by 12,000 to a seasonally adjusted 377,000 in the week ended June 2 and beating analyst forecasts. Also, the Conference Board disclosed that its employment-trends index moved higher by 0.29% in May with the data provider stating, “Employers have been very cautious in hiring in the past two months, but at the moment, economic activity in the U.S. is just strong enough to require a modestly growing workforce.” Finally, the Institute for Supply Management said that its index of nonmanufacturing activity inched higher to 53.7 in May, up from 53.5 in April, with any reading above 50 (where the gauge has been now for 29 straight months) signifying expansion in the service sector.
True, economic conditions are hardly robust, especially as the Commerce Department also reported last week that factory orders dropped 0.6% in April, following a revised big decline of 2% in March, but we would continue to argue that stock prices are discounting a worse economic climate than is likely to materialize. Standard & Poor’s, which affirmed its 'AA+' long-term and 'A-1+' short-term U.S. sovereign credit ratings this past Friday afternoon, stated that its base case expects annual real GDP growth of 2%-3.5% and consumer price inflation near 2% through 2016, outlooks that appear to be in line with what we’ve heard from the Federal Reserve as well as private economists.
Most importantly, perhaps, though estimates have been coming down in recent weeks due to the turmoil in Europe where something on the order of 15% of sales for companies in the S&P 500 are generated, Standard & Poor’s now projects that bottom-up operating earnings per share for the S&P 500 will grow from $96.44 in 2011 to $104.54 this year to $118.51 in 2013. With the benchmark not that far above 1300, equity valuations remain quite reasonable in our view, especially when interest rates are hovering near all-time low levels.