Markets Decline Despite Fed Action

Equity markets struggled to maintain two weeks of gains last week, as a dimmer Fed outlook and lack of policy action in Europe weighed on stock prices.  The S&P 500 fell 0.6% while the Dow Jones Industrial Average declined 0.9%.

The Federal Reserve concluded its two-day policy meeting on Wednesday.  As expected, the committee extended the Operation Twist program, whereby the Fed sells shorter-term Treasuries and purchases longer-term Treasuries, until the end of the year.  The length of the program was slightly longer than consensus, however, which generally believed the Twist program would be extended three months.

The Fed also shifted its language, noting that it was “prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”  This was slightly more aggressive than previous statements, with many analysts believing the committee is referring to QE3.  Additional language in the press release that noted inflation was at or below its target rate appears to clear the path for such action.

Markets were mixed in the immediate aftermath of the statement, perhaps reflecting either disappointment with the scope of the Fed’s plans or the feeling that the Fed has limited ammunition to battle a slowing economic environment.  The S&P 500 fell 1.3% from the time of the FOMC release to Friday’s close, contradicting the typical bounce markets have exhibited following other new policy actions.

Ratings agency Moody’s downgraded 17 global banks last week, although none were more than forecast.  This led to an uptick in many affected banks’ share prices and improvement in CDS pricing. The agency announced it was reviewing the banks in February, leading the market to mostly price in its negative effects.

Many viewed the positive market response to the downgrades as an affront to Moody’s, which has been widely ridiculed along with other ratings agencies, for being too slow to reflect prevailing credit conditions.  The downgrades could have an impact on operational costs for some companies, however, as lower rated banks will likely need to post higher collateral for derivatives transactions.

In what has become a familiar refrain, economic data was relatively disappointing last week.  Important indicators on the housing market were generally sluggish, and manufacturing measures suggested a continued slowdown in the sector.

The week started with the National Association of Home Builders (NAHB) Housing Market Index (HMI), which ticked up slightly to 29 from May’s reading of 28.  Unfortunately, this improvement was offset by May’s downward negative revision.  The HMI is based on surveys of homebuilders, evaluating their perceptions of sales, sales expectations, and prospective buyer “traffic.”

The NAHB measure has risen sharply since the fall of 2011, and is at its highest level since May 2007.  Unfortunately, the index has been in a holding pattern since February when it first reached 28.  This development seems to mirror stagnation seen in other housing indicators.

Housing starts disappointed on Tuesday after missing consensus expectations by 12,000.  At 708,000 starts, May’s reading was actually unchanged over the month after April was revised downward from 718,000.  The trend in this indicator has slowed considerably in recent months after improving sharply through most of 2011.

This trend could abate soon, however.  A divergence is occurring between housing starts and building permits, with the latter generally foretelling an uptick in future activity.  Permits rose an astounding 57,000 in May, blowing through estimates of 736,000.  Although there was a brief dip in April, permits have risen markedly since the year began.

On Thursday, the National Association of Realtors (NAR) reported existing home sales fell slightly in May, declining to 4.55 million from 4.62 million in April.  NAR Chief Economist, Lawrence Yun, attributed the fall to “supply constraints rather than a softening of demand.”  He noted that,   “the normal seasonal upturn in inventory did not occur this spring.”  Moreover, the release pointed to general uptrends in all regions.

Notably, prices firmed in the report to a median level of $182,600 in May, 7.9% higher than one year prior.  Part of this is due to the decline in distressed transactions; the measure fell from 28% in April to 25% in May.  One year ago, that measure stood at 31%.  Clearing out the overhang of distressed inventory is critical to normalization of the housing sector of the economy, making May’s report somewhat encouraging.

Manufacturing data continued to disappoint last week, as Markit Economics’ new flash PMI report indicated the sector softened in June.  Thursday’s reading was 52.9 – still in expansionary territory, but a full point below May’s level.  This foreshadows a weaker ISM report due out in early July.

In a follow-up to last week’s New York regional Fed survey, the Philadelphia Fed survey plummeted an additional 10.8 points in June, falling to -16.6.  This level indicates contraction, nearing the recovery-period lows set last summer.  When combined with weakness in the Empire State and industrial production reports, manufacturing appears headed for another later summer slowdown.

Persistent negative economic data in the US continues to weigh on the Citigroup Economic Surprise index.  At -64.8, the index is now at its lowest level since August.  Unfortunately for investors, stock prices have tracked closely with the index during the past couple of years.  On the other hand, if economists reset their expectations conservatively enough, economic data could start surprising to the upside and boost market sentiment – similar to the phenomenon seen last year.

 

Jilted Investors Unsure Where to Turn

Consistent with recent years, equity markets have caught many investors flat footed in 2012 through a series of tumultuous ups and downs.  After the first quarter, the S&P 500 Index was up 12.6% and seemingly on its way to one of the better calendar years of the past decade.  With the flick of the European switch, markets reversed course and sentiment quickly moved in the opposite direction.  At the current juncture, retail and institutional investors are equally unsure of the future, suggesting the markets are in a very bimodal state. 

Within the institutional investor community, sentiment has vacillated rapidly in response to recent market moves.  After a peak in sentiment in July of last year, according to the Investor Confidence Index compiled by State Street, institutional investors in North America became bearish and never reversed course, despite the market rally.  As of May, the index showed a reading of 88.0, well below the 106.2 reading in May of last year. 

Retail investor sentiment followed a similarly interesting path this year.  Entering 2012, retail sentiment, as measured by the American Association of Individual Investors (AAII), showed that roughly 49% of retail investors were bullish on the six-month outlook for stocks, and a mere 17% were bearish on the outlook.  As the quarter progressed, and stocks continued to rally, the percentage of retail investors remaining bullish stayed above the long-term average (39%).  By April, however, the retail community became more downbeat on the outlook. 

In the May 23 survey, a mere 24% of retail investors expressed a bullish outlook on stocks and an overwhelming 46% were bearish.  That date coincided almost exactly with a brief rally that lasted into month end. 

Currently, following the rally that began at the start of June, 33% of retail investors are bullish on the equity outlook, and 36% are bearish.  This remains slightly at odds with the long-term averages, but no longer stands at the extreme readings from mid-May.

Source: Pragmatic Capitalism

Undoubtedly, investors are struggling to quantify the situation in Europe, as well as the possibility of spillover effects in the remainder of the world. 

Particularly frustrating for investors, though, is the sense that diversification offers little to their collective portfolios given the impact of macroeconomic news on markets right now.  In fact, Bespoke Investment Group discovered that since May, 16 days ranked as “all or nothing days” for the S&P 500.  This means that 400 or more stocks in the S&P 500 Index rose or fell on the same day. 

Source: Bespoke Investment Group

While that pales in comparison to the 70 such days in 2011, on an annualized basis it represents the fifth highest number of all-or-nothing days in a calendar year since 1990. 

The rising number of macro-influenced days is also pushing correlations back to extremes, just as they were beginning to retreat.  Earlier this year, the average correlation among stocks in the S&P 500 was 0.4, the lowest since late 2010.

Source: Thomson Reuters

To combat concerns in the equity markets, investors are turning to corporate bonds in a massive way.  The perceived safety and stability afforded by the corporate bond sector, as well as improving corporate balance sheets lends itself to an attractive environment for the space. 

Source: BCA Research

Institutional and individual investors are at an uncertain juncture, waiting to see what the next shoe to drop is.  With an important series of events occurring soon, such as the US Presidential election this fall and the “fiscal cliff” facing the US at year’s end, investors may need to wait to get more clarity on the market outlook.

 

the week ahead

There are several important indicators on tap for next week, headlined by the third and final release of first quarter GDP.  No change is expected from the second estimate of 1.9%.

Other important results are due on the housing market, including new home sales and the Case-Shiller home price index, and the consumer, including consumer confidence and the personal income and outlays report.

Other important events to monitor include a possible ruling on the Affordable Care Act by the Supreme Court.  The verdict will have a significant impact on all Americans, as well as the health care industry and potentially this fall’s presidential election.

In Europe, EU leaders will meet in Brussels for a summit on June 28-29, which could yield incremental improvement in the sovereign debt crisis.  This could include an integration of the union’s banking system.

Central banks meeting this week include Israel, Hungary, Brazil, Romania, Czech Republic, and Colombia.

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