An Alternate Reality
By Robert Stimpson
October 22, 2012
The US stock market continued rising in the third quarter of 2012, adding to an already impressive year-to-date return. The S&P 500 has gained 16.44% year-to-date after gaining 6.35% in the third quarter. Oak Associates’ accounts also performed well during the quarter as large-cap stocks climb a wall of worry perpetuated by the presidential election cycle and ongoing economic concerns in Europe and China. The disconnect between stock prices and the economy is explained by the forward-looking nature of equities compared to economic data. While the global economy does have issues, the outlook is improving and stock prices reflect this.
The largest positive factor affecting the environment for stock prices this year has been the recovery in the housing sector. After years of struggle, the sector appears to have turned the corner. The housing market had been showing signs of improvement for some time, but the debate as to whether the recovery was legitimate weighed on the group and added to concerns over the economy. Nevertheless, the National Association of Homebuilding (NAHB) Index reached a five year high this quarter, confirming the drawn out recovery has legs. Not only is homebuilding activity up, but prices are rising in many markets, foreclosures have slowed, and investors have absorbed excess inventory in favored markets. The recovery has been painfully slow, but a healthy housing market bodes well for the broader stock market for several reasons.
First, consumer spending is tied to consumer sentiment. When concerns over the economy, job growth, and the value of homes look bleak, the consumer is restrained. Combine a frugal consumer with a tight credit market and an economic recovery is difficult. With a pick-up in house prices, consumer sentiment should improve. Since sentiment transcends businesses and affects hiring, a full-fledged economic recovery is more sustainable with a stable housing market.
Second, the banking sector is exposed to the housing sector through collateral and credit markets. As a large source of collateral for banks, a pick-up in home prices alleviates balance sheet concerns and facilitates additional loan growth. Collateral, access to credit, and loan growth all act as lubrication for an economy. An improvement in this formula further supports the progress equity markets have achieved this year.
The main event for the third quarter was the Federal Reserve’s announcement of Quantitative Easing 3 (QE3). The bond purchasing intervention is designed to keep interest rates low and encourage attractive mortgage rates for new borrowers and refinancers. Low rates may have helped the housing market recovery, but economists still debate whether the artificial pressure on mortgage rates caused the recovery or simply accompanied it. Regardless, the continued low interest rate environment is considered stimulative to stock prices and the consumer.
The latest round of stimulus was quickly referred to as QE-infinity by Wall Street due to the open-ended structure of the intervention. This was done to avoid the post-QE letdowns which occurred following the first two rounds of easing. The combination of the open-ended easing, an economic recovery, and stronger consumer raises the threat of inflation longer term. This is something we will continue to monitor going forward. Thus far, there is sufficient slack in employment and global economic activity to counter the threat of rising prices and wages.
Within the market, several trends are worth noting. The outperformance of large-cap stocks was noticeable. Whether it is the perceived safety of a blue-chip company, the appeal of dividends compared to low bond yields, or the global exposure of large companies, their outperformance disproportionately enhances the returns of benchmark indexes compared to the average equity portfolio. Apple, for example, has risen 65% year-to-date and is now the largest company in America. When the largest stock is such an outstanding performer, the returns of the popular cap-weighted averages are skewed. The performance of the mega caps will also make it difficult for portfolio managers to outperform the benchmarks simply because they cannot own Apple at a 14% weighting like the Nasdaq 100 Index for example.
In conclusion, the performance of US markets punctuates the improved economic environment and stands in contrast to election media propaganda. Problems in Europe continue to add volatility occasionally, but the situation is well understood and a solution will eventually develop. China, which is a leading exporter to Europe, had suffered more from the economic turmoil abroad and is stimulating internal consumption to offset its export markets. Given its reserves and breadth of control over the economy, it is likely to succeed. While a recovery in Europe would be helpful, it is not essential to having a strong market. Valuations for US equities remain attractive, balance sheets are strong, and prudent capital discipline should support earnings growth going forward.
Robert Stimpson, CFA
Oak Associates, ltd.
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