Markets Rebound From Two-Week Slide

Markets rebounded last week after a two-week slide.  The S&P 500 and Dow Jones Industrial Average rose 1.7% and 0.7%, respectively, in a choppy trading period.  Discussion of a potential Greek exit from the Eurozone rattled investors, while economic data in the US was modestly positive.

Several important housing indicators were released last week, beginning with existing home sales on Tuesday.  The report revealed improvement in April, as sales increased 3.4% from the month prior and 10% higher from year-ago levels.  This was roughly in line with consensus expectations.

There were a few positive developments in the report.  Most notably, median home prices rose 10.1% in year-over-year data.  This followed a 3.1% increase in March.  According to the National Association of Realtors’ Chief Economist Lawrence Yun, this was “the first time we’ve had back-to-back price increases from a year earlier since June and July of 2010 when the gains were less than one percent.”

This trend was partially driven by continued improvement in the number of distressed transactions (foreclosures and short sales), which have been depressing home prices since the housing crisis first erupted.  The shares of distressed purchases fell to 28% in April, compared to 29% in March and 37% in April 2011.

New home sales also improved in April, rising to a seasonally adjusted annual rate of 343,000 homes.  This topped expectations for a 335,000 rate, and was 11,000 higher than March.  Additionally, an annual revision to the data series by the Census Bureau adjusted the pace of sales in nine of the previous 13 months higher.

Although moving in the right direction, April’s data for new home sales does not erase the fact that this sector remains terribly depressed.  In mid-2006, this series reached more than one million sales, before falling (and remaining) well below 500,000 for virtually all of the past three years.  The gradual decline in distressed transactions for existing homes should help this area of the housing market, but much work remains for it to heal completely.

Investors received more information on the housing sector on Wednesday, when the FHFA Price index was released by the Federal Housing Finance Agency.  Although not representative of the entire US housing stock, as the series generally reflects higher quality properties (agency-owned), it was clear that there is improvement occurring in home prices.  The index rose 1.8% in March, by far the biggest monthly increase in the past three years.  This helped drive a 2.7% year-over-year price change, which is just the second month in positive territory since the recovery began.

Some analysts have cautioned that the dramatic move in the series may have been caused by external factors.  According to Econoday, FHFA mortgage insurance premiums are scheduled to increase in April, leading to a surge in mortgage applications in late March.  This temporary increase in demand may explain some of the jump in home prices.

Two manufacturing reports during the week increased concern that the primary bright spot of the economic recovery is fading.

Durable goods, released on Thursday, increased less than forecast in April.  The series advanced 0.2%, below expectations for a 0.5% gain.  While this series is fairly volatile on a month-to-month basis at the headline level, a surprising decline in the “core” data of 0.6% underscores a softening in the broader manufacturing complex.  This was the second such month of contraction at the core level, and it follows mixed regional Fed manufacturing surveys last week.

All eyes will be on the Institute of Supply Management’s manufacturing PMI, due out next Friday, to see if this weak patch persists.  The report unexpectedly rebounded in April, but if Markit Economics’ flash PMI for May is any indication, the report may decline.  Markit’s flash indicator, released on Thursday, fell from 56.0 in April to 53.9 in May.  While this is still in expansionary territory, export growth stagnated, giving credence to the concern that slowing in Europe and China is filtering over to the US.

The weakness in US economic data and growing turbulence in equity markets do not appear to be weighing on consumer psyches.  The University of Michigan Consumer Sentiment Survey, released on Friday, rose to its highest level in four years.  At 79.3, the index is nearly three points higher than a month ago, with particular strength occurring in the report’s expectations component.  Falling gas prices and general labor market improvement appear to causing consumers to upgrade their collective outlooks for the future.

 

Amid Uncertainty, What is An Investor To Do?

After a stellar start to the year for risk assets, investors are once again facing an uncertain macroeconomic outlook.  Treasury yields are falling, equities are selling off, and there is a growing chorus of negative sentiment in the markets.  The rest of the year is expected to be equally as volatile, but for patient investors, small positive developments are bubbling to the surface. 

For some investors, the most surprising occurrence recently may be the rally in Treasury bonds.  Investors thought weakness in US Treasury yields in early March was the start of the long awaited bond market rout, but alas, that was not the case.  Since that time, yields have fallen dramatically and currently stand at unprecedented levels. 

At the start of the year, 10-year Treasuries yielded 1.9%.  Following several months of choppy trading, yields began a sharp trek higher, reaching nearly 2.4% by mid-March.  As economic data began to weaken and European fears reemerged, though, yields retraced all of their lost ground.  Within the last week, yields on the 10-year Treasury hovered below 1.7%.  Is there reason to worry Treasury markets see something overlooked by others?

 

Source: Chart of the Day

As investors are all too familiar with at this point, Treasury yields have been in secular decline in the past several decades, benefiting from numerous long-term tailwinds. 

One catalyst behind the recent decline in yields is positioning in advance of numerous risks, not least of which is the 2013 “fiscal cliff.” 

Source: Goldman Sachs

According to recent analysis from the Congressional Budget Office (CBO), a slew of fiscal changes set to occur at the start of 2013 are likely to send the U.S. economy back towards recessionary territory.  By the CBO’s estimates, without changes to pending tax expirations, the economy will contract by more than 1% at the start of next year.  Goldman Sachs agrees, estimating a near 4% headwind to growth barring any change. 

Bond and equity markets are acutely aware of those concerns.  After a short period of positive fund flows, equity mutual funds are once again experiencing net redemptions.  Lipper reported that the four-week average outflows from equity funds was $1.4 billion through this past Wednesday.  

 Source: Barron’s

 

The argument that this is simply an extension of investors abandoning equities may not be entirely true, though.  It is clear that equity mutual funds are suffering withdrawals, but it may simply be a case of investors seeking the lowest cost alternative. 

Assets in exchange-traded funds (ETFs) ended April at $1.187 trillion, up from $1.113 trillion one year prior.  Domestic equity ETFs have seen some of the fastest growth, picking up more than $40 billion in overall assets in the last year. 

At the same time, however, a generation of investors is growing up with little reason to believe in stocks.  Situations such as J.P. Morgan’s risk gaffe and Facebook’s disappointing IPO perpetuates a long held belief for retail investors that markets are “rigged.” 

MFS Investment Management recently conducted an investor sentiment survey in which they found that 40% of Generation Y believes the statement “I will never feel comfortable investing in the stock market.”  The experiences of the last decade have undoubtedly jaded this young group.

But, as is typically the case, once in a lifetime opportunities are most prevalent in periods when others are looking in the opposite direction.  Just consider European equities, for instance. 

The dividend yield on the Euro Stoxx 50 Index is currently 2% higher than 10-year German bunds.  Since 2001, the only other instance of that happening occurred in late 2008.  Undoubtedly, there is concern about the future of Europe, but the large, multi-national approach of virtually all countries in the Euro Stoxx Index means they do not readily depend on revenues from the European region. 

Source: Reuters

 

U.S. equities are in a virtually identical situation.  Within the S&P 500 Index, there are more than 270 companies with a dividend yield higher than the 10-year Treasury. 

Source: Bespoke Investment Group

All the while, markets seem more dangerous and discouraging than ever.  Not everyone thinks this is a dangerous inflection point, though.  Common volatility measures such as the VIX are up slightly since the low in March, but remain well removed from the peaks seen in the fall of 2008, May 2010, and August 2011.  This suggests investors are fearful of markets, but not to the point of outright panic. 

Source: Bloomberg

 

With so much uncertainty looming, investors should simply do what they always do.  Read the tealeaves, understand the macro backdrop, and continue to hold a diversified portfolio of assets. 

 

The Week Ahead

The holiday-shortened week includes several economic reports of significance, highlighted by the second estimate of Q1 GDP and the government jobs report.  Consensus expects a slight negative revision to GDP while the economy was expected to have added 150,000 jobs in May.

Other important indicators include the ISM Manufacturing PMI, personal income and outlays, consumer confidence, and the S&P/Case-Shiller Home Price Index.

Corporate earnings are mostly completed at this point, but several companies are offering sales/trading updates this week, including Ford Motor and a rash of retailers such as Gap, Kohl’s, Macy’s, Nordstrom, Saks, Target, Costco, Limited Brands, and TJX.

Central banks meeting this week include Colombia, Israel, Turkey, Hungary, Brazil, and Russia.  Brazil is expected to cut its overnight Selic rate by 50 bps.

 

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