Perception Versus Reality
By Liz Ann Sonders, Brad Sorenson, and Michelle Gibley
August 27, 2010
- Market volume continues its traditional August swoon, making it difficult to gauge much from stock market action. Economic data continues to tell a mixed story, as growth slows and risks rise.
- Confidence is key to consumer spending, business investment and stock market performance. The Federal Reserve and the government are attempting to instill that confidence in the American public, but so far have had little success.
- Emerging markets continue to show signs of growth and China's market has been performing well. Germany also has posted some nice numbers lately, but Japan remains a concern.
With the Dow Jones Industrial Average posting triple-digit gains and losses during the past couple of weeks, it can be easy to get caught up in overreaction. However, these market moves have occurred on some of the lowest trading volume days of the year, meaning that they're hardly a referendum on the overall consensus of market participants.
In fact, during the past month, there's been little consensus as the overall market indexes are roughly flat. Bears have pointed to deteriorating economic data as a sign of an impending double-dip recession, while bulls have directed attention to a good earnings season, increasing merger-and-acquisition activity and continued accommodative monetary policy.
This again illustrates the folly, in our opinion, of trying to time the market. Where the market goes in the near term is virtually impossible to predict. Following the recent Federal Open Market Committee meeting where the Fed demonstrated its commitment to continued extremely accommodative monetary policy, the market initially responded relatively well, only to sell off during the next trading day.
Additionally, we want to again caution investors about reading too much into so-called technical indicators. While they can be a tool in your overall market analysis, there's little evidence that the majority of indicators can be consistently relied upon.
Recent attention has been paid to the "Hindenberg Omen," a relatively complicated set of technical conditions which has preceded every market crash since 1987 that was recently breached. However, it's important to note—but is rarely reported—that this indicator has flashed multiple times during the past 20+ years when there hasn't been a crash. In fact, more than 75% of the time the Omen has been a false signal, according to The Wall Street Journal.
We continue to advocate a long-term view on equity investments. If you need money in the near term, don't invest it in equities—short-term performance can be too volatile.
That doesn't, however, mean to just buy and ignore your investments. It's important to use dips and rallies to add or subtract to positions as necessary and to monitor your investments to track changes in approach, style or performance and adjust as necessary.
Economic growth slowing, but remains positive
Although rhetoric surrounding a double-dip recession has increased throughout the summer, we remain relatively optimistic that economic growth will remain positive (albeit low) and that from a sentiment and valuation perspective, the stock market appears relatively attractive. While volatility will continue, alternatives to stocks are relatively unattractive.
Yields on bonds are near all-time lows, while interest rates on cash deposits remain at virtually zero. Meanwhile, the dividend yield on the Dow is approximately 2.9%, greater than the 10-year Treasury yield of approximately 2.5%. Maintaining a balanced, diversified portfolio is important and we believe that for most investors, it makes sense to keep some of your portfolio in stocks.
While we don't think we're slipping back into recession, risks are rising and warrant watching. Initial jobless claims remain stubbornly high, with a recent reading again hitting the 500,000 mark, the highest level since November of last year.
Housing also continues to languish, as housing starts were up 1.7% in July, but more forward-looking building permits were down 3.1%. Adding concern, existing home sales fell 27.2% in July to the lowest level in 15 years, as inventories surged to 12.5 months worth of supply.
These results should be taken with a grain of salt, however, as the April expiration of the Federal tax housing credit continues to distort numbers. We continue to believe that historically low mortgage rates and record affordability will help support the housing recovery—but that it will be a slow process and could bounce along the bottom for some time.
Positive news also exists (though it's getting less attention) as both Institute for Supply Management surveys remain in expansionary territory and the recent industrial production reading gained a surprisingly strong 1% month over month. We still believe positive economic growth is the most likely course, as we turn to the Index of Leading Economic Indicators (LEI), which posted a 0.1% gain in July and are still in territory indicating economic expansion.
Leading economic indicators still signaling expansion
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Source: FactSet, US Conference Board, as of August 24, 2010.
In fact, according to BCA research, of the 10 underlying components that make up the LEI, six are either flat or rising, indicating some decent underlying strength.
And we don't want to overlook the historically best predictor of recessions, the spread in the yield curve. There's been talk lately that the low end of the curve has been held artificially low through the actions of the Fed, thereby rendering the predictive power of the yield curve mute.
We caution against the "this time is different" mentality—we've heard it many times in the past, and rarely has it truly been different. As of now, the yield curve (though flattening modestly as economic growth has weakened) remains relatively steep, indicating low probability of an impending recession.
Yield curve not signaling recession
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Source: FactSet, Federal Reserve, as of August 24, 2010.
Confidence is key
One of the major keys to improving the housing and labor markets, as well as boosting economic growth, is for confidence in the economic system to return. There are small signs that it's slowly returning, although they remain tenuous.
The recent Federal Reserve Senior Loan Officer Survey on Bank Lending Practices showed that lending standards eased somewhat during the past three months. In fact, for the first time since 2006, big banks' standards for small businesses eased, potentially freeing up credit for the all-important small-business sector.
However, loan demand remains roughly unchanged, indicating continued uncertainty. Businesses wary of economic prospects, political policy and tax status are extremely hesitant to invest in capital or hire new workers—and if your competitors aren't hiring or investing, there's less incentive for you to do so.
The Fed is still trying to reassure markets that it will remain stimulative for the foreseeable future. In fact, during its last meeting, the Fed made the largely symbolic gesture of reinvesting proceeds from paid-off agency securities rather than let its balance sheet decrease by even that small amount.
While we don't know if this is the best course of action, and worry that the Fed has stayed at the well too long (rendering low rates somewhat ineffective) the Fed is undoubtedly committed to doing its best to avoid a repeat recession.
Confidence in the economic policies of the government, both federal and local, seems to be near its lowest levels in recent memory. States and municipalities continue to struggle with large budget deficits, requiring the cutting of services and laying off workers, while the federal government can't seem to decide on its best course of action.
On the one hand, talk continues of another stimulus package, while, according to The Wall Street Journal, approximately $164 billion of the $230 billion allocated toward infrastructure projects during the last round of stimulus remains unspent.
The Obama administration is searching for ways to entice businesses to hire more workers, while at the same time issuing new regulations and policies that make it more expensive to do business. Meanwhile, talk of raising taxes on many small businesses continues.
While we've always tilted toward the side of free markets, it appears to us that the government needs to provide some certainty going forward, whatever its approach may be. Businesses can adapt to many things, but they need to know the ground rules before they feel confident enough to move forward—confidence they apparently don't have right now.
Emerging markets buoy global growth
Confidence is also an issue internationally, with increasing concerns about the prospect of a global double-dip recession. However, we look to the strength of emerging-market economies to help keep global growth positive. Emerging-market economies have grown in importance, advancing 2.5% in 2009, almost enough to offset the 3.2% decline during the developed-economy recession, as the world economy fell 0.6% in aggregate in 2009.
Growth in advanced economies will likely be at low levels in 2010 and 2011, and while a global double dip is a growing risk, we believe it's still a low-probability event.
Meanwhile, emerging markets are forecasted to grow faster, as they're largely unburdened by the high levels of government and consumer debt that exists in much of the developed world, and banks tend to be healthier. Additionally, consumers have become an important part of the growth in many emerging countries as household incomes rise, as we've discussed in articles on Brazil and India.
China slowing, but no hard landing
Many emerging markets tend to have their growth tied to economic prospects in China, which has been a primary source of global growth. While exports are an important part of the Chinese economy (but could slow in coming months), fixed investment is the highest percentage of China's gross domestic product (GDP) at nearly 50% in 2009, propelled by property construction and government stimulus spending on infrastructure.
We expect infrastructure and property construction in China to slow over the near term as government stimulus levels off and the housing market is affected by measures intended to cool speculation. Encouragingly, steep property price declines have catalyzed sales, but we expect additional supply in coming months, further suppressing prices. The Chinese property market benefitted from rapid loan growth and wealthy individuals' speculative investments, as there are few investment options in China.
With property prices falling, the government ordered bank stress tests. Chinese banks lack transparency, but we don't think a collapse in the banking system is likely. Banks announced plans to raise $96 billion this year to strengthen their balance sheets, and a majority are state-owned, boosting their viability.
China's economy is slowing, but the government strives to maintain 8% growth to keep employment high and to avoid civil unrest. Unlike many developed countries, China has the pocketbook to issue new stimulus if growth slows too much.
It's probably too soon for China to restart stimulus, but we continue to believe further tightening has been delayed. The outperformance of the Shanghai Composite relative to the S&P 500® index during the past the six weeks is notable, as this market has led in recent years.
China outperforms as tightening delayed
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Source: FactSet, Shanghai Stock Exchange, Standard & Poor's, as of August 25, 2010.
We remain constructive on emerging-market equities, as their higher growth outlook and below-average multiples gives them the ability to continue to outperform developed-market stocks.
A tale of two exporters: Japan's dominance slips, Germany surprises to upside
Businesses allowed inventories to plunge so they could conserve cash given high uncertainty during the recession. As a result, the global recovery was driven by manufacturing and exports, benefitting from inventory building, as well as low levels of positive demand.
However, now that inventory building appears to be leveling off and with global growth slowing, many economies can no longer rely solely on exports for growth. Many countries need internal consumption to take the economic baton and help make the recovery self-sustaining.
As such, the lack of consumer spending by Japan's aging population, amid a deflationary environment wherein spending is postponed, reduces Japan's outlook. Additionally, the surging yen has reduced exporters' prospects.
In fact, Japan ceded the position as the second-largest economy in the world to China during the June quarter, and China's higher growth implies that this situation is likely to persist.
Japan loses no. 2 position to China
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Source: FactSet, International Monetary Fund, as of August 25, 2010. Note: 2010 figures are estimates.
While Japan seems poised to benefit from China's growth, and China accounted for 20% of the Japan's June exports, Japan imports more from China than it exports. For the time being, the two countries appear to be working as partners to produce goods destined for consumption elsewhere.
On the other hand, Germany's economy has been surprisingly strong, with its prominent export sector benefiting from a declining euro. The pace of GDP growth is likely to slow from the 9% quarter-over-quarter (q/q) annualized pace in the second quarter, which also benefitted from a construction rebound after being held back by poor weather in the first quarter.
However, German private consumption in the second quarter rose 2.4% q/q annualized, the first increase since the second quarter 2009. In contrast to the near-term outlook for Japan, if German consumers continue to spend, the recovery could enter a self-sustaining phase and boost Europe overall, as Germany constitutes about a quarter of the region's economy.
Central bank action influences currency outlook
The Fed's move to maintain the size of its balance sheet effectively delays its exit strategy. Additionally, comments from the Bank of England's chief, Mervyn King, indicate that the BoE appears to be considering the possibility of extending further stimulus.
Meanwhile, the European Central Bank (ECB) remains opposed to providing stimulus, barely budging even in the face of a market riot over government debt in the second quarter.
However, the Bank of Japan's lack of action has confounded market watchers. Japan may have entered a liquidity trap amid a deflationary environment, wherein injections of money fail to catalyze lending and spending as purchasing decisions are postponed. A surging yen increases the probability of action by the BoJ, using either unconventional monetary stimulus or currency intervention.
Double-dip recession fears have created demand for the safe-haven status of the US dollar. Additionally, the euro worked off some of the sharp rebound after plunging amid the euro-area debt crisis this year. With the euro comprising 58% of the US Dollar Index (which measures the performance of the US dollar against a basket of currencies), we expect the index to fall as the dollar weakens, as the Fed could exit monetary stimulus later than the ECB.
The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.
The MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.
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