Up and Down Wall Street
Markets: What Everyone Knows That Isn’t So
U.S. shares recovered, bond yields stayed low, gold rose, the dollar fell, and EMs surprisingly did better.
By Randall W. Forsyth
In a speech last week, she took note that falling bond yields were helping to offset the tightening in financial conditions wrought by the slide in the equity markets and the widening of credit-risk spreads (a product of the debt-deflation vise squeezing the high-yield bond market), which came after the central bank’s implemented its initial rate hike after keeping its policy target near zero for seven years. Global developments, notably the weakness in China and other emerging economies, also served as counterweights to the steady but modest pace of the U.S. economy.
JPMorgan’s GDP tracking model shows a somewhat better, if still tepid, 1.2% growth pace.
That would be another unanticipated outcome for this surprising year.
Utilities, telecoms, and consumer staples all were winners, even to the extent that these stolid stocks have been bid up to price/earnings ratios that are half again the 17 times expected 2016 earnings that the broad market commands.
The thing about a roller coaster is that you get off at the same place as you got on, but you might feel queasy after the ride.
It’s unlikely that investors thought they were buying tickets to the markets’ version of the Coney Island Cyclone when they started out the year. As usual, most strategists were assuring them of a mild, instead of wild, ride, with high single-digit returns.
Instead, global equities returned all of 0.4% for the first quarter, according to Bank of America Merrill Lynch’s tally, with U.S. stocks providing just 1%. But that was after a double-digit plunge in the first few weeks of 2016, followed by a sudden climb in the final weeks.
Still, the U.S. fared a good deal better than other developed markets, with Europe down 2.4%, the United Kingdom off 2.3%, and Japan worse by 6.4%—a surprise because overseas markets were touted as the places to be. That is, except for emerging markets; but their results also confounded the seers, as they returned a robust 5.8% for the quarter.
Once again, magazine covers gave clues to the contrarians. As Paul Macrae Montgomery pointed out many times in this space, when magazine editors catch on to something or somebody, it has long been digested and discounted by the markets. The magazine cover is a sign that some tide is about to crest or to rise.
That notion was caught perfectly by Walter Zimmermann, the market maven at United-ICAP. Back in January, he took note of a negative Brazil cover story in the Economist (the first of several) featuring the travails of the country’s president, Dilma Rousseff, and contrasted it with Time magazine naming Germany’s Angela Merkel its Person of the Year and indeed, “Chancellor of the Free World.”
The magazine covers tipped off investors to the fact that those perceptions were discounted in the markets. “The broadest implication is the contrarian value of ‘long-Brazil-short-Germany’ perspective. The most narrow interpretation is that Dilma is oversold and Angela is overbought,” Zimmermann wrote on Jan. 21.
And so the iShares MSCI Brazil CappedEWZ in Your Value Your Change Short position exchange-traded fund (ticker: EWZ) returned 27.18% in the first quarter, while the iShares MSCI GermanyEWG in Your Value Your Change Short position ETF (EWG) had a negative 1.76% return.
The reversals of fortune affected the entire investment universe, with a tidal change coming on Feb. 11.
From the turn of the year until that date, volatility rose as the collapse in crude oil and other commodities continued. Against that deflationary backdrop, Federal Reserve officials were sticking to their December script that four interest-rate increases in 2016 were “in the ballpark,” as the central bank’s vice chairman, Stanley Fischer, put it.
Crude found a bottom, for now at least, around $26 a barrel, and the major central banks, led by Mario Draghi’s European Central Bank, turned full-tilt expansionary (although the Bank of Japan’s introduction of negative interest rates in late January failed to have the desired effect).
Whatever the impetus, the change in the roller coaster’s course was dramatic. From an 11.3% negative return through Feb. 11, global equities rallied 13.2% to end the quarter barely positive. U.S. stocks went from being thrown for a 10.8% loss to a 13.2% gain, winding up ahead by 1%. And emerging markets went from being behind by 10.1% to a 17.7% rebound, and ended up nearly 6% for the first three months.
At the beginning of 2016, “everybody knew” that bond yields had nowhere to go but up (and their prices had to fall), while the dollar was certain to continue its ascent and gold could only drop. Wrong on all counts. Global government bonds were the place to be, with a 6.9% return, according to BofA Merrill, except for the Pet Rock of gold, which scored a 16.1% gain. That came as the greenback lost 4.1%, especially owing to the Fed’s relenting on rate hikes.
Fed Chair Janet Yellen has given notice that the central bank won’t be fighting the proverbial tape.
While the so-called dot plot of expectations of central-bank solons at last month’s meeting of the Federal Open Market Committee predicted two increases in the federal-funds target rate by year end—from the current 0.25%-to-0.5% range—the fed-funds futures market is pricing in only a single hike by December, and with just a 61.7% probability. “Low for longer” remains the most likely course for rates after the first batch of major March data was released on Friday.
The monthly jobs report showed a 215,000 increase in nonfarm payrolls, insignificantly higher than economists’ consensus guess of 205,000. The jobless rate inched up slightly, to 5% from 4.9%, but for the positive reason that more folks were actually looking for jobs. Average hourly earnings ticked up by 0.3%, reversing February’s dip and leaving the year-on-year increase at 2.3%.
That could be as good as it gets, however. Josh Shapiro, chief U.S. economist at MFR, thinks “declining corporate profit margins will prompt aggressive cost-cutting and thus a slower trend for nonfarm-payroll growth late this year and into 2017, which in turn will lead to a slower trend for consumer-spending growth.”
It’s too early to expect these trends to show up in the numbers, he avers. But first-quarter gross domestic product is tracking just a 0.7% annual rate, according to the Atlanta Fed’s GDPNow model.
Decent employment gains, combined with sluggish GDP growth, is consistent with persistently slow productivity trends. The push to raise the minimum wage to $15, which gained further impetus in New York and California last week, will probably add to the squeeze on profit margins to which MFR’s Shapiro alluded. Perhaps it will also spur productivity gains, as machines become more-economical replacements for workers who may be too expensive at $15 an hour, plus payroll taxes.
GIVEN THE STOMACH-CHURNING SWINGS in stocks in the first quarter, and the continued firmness in bonds, it’s perhaps not surprising that the equities most in favor were the most bondlike.
Indeed, the Utilities Select Sector SPDRXLU in Your Value Your Change Short position ETF (XLU) hit a record high on Friday after coming off a 15.52% first-quarter total return, according to Morningstar. The Vanguard Telecommunication Services VOX in Your Value Your Change Short position ETF (VOX) racked up an 11.11% return, while the Consumers Staples Select Sector SPDR ETF (XLP) returned 5.63%.
Investors’ eagerness to pay up for safety may be understandable, not only because of the rocky road they’ve traveled, but also due to the risks they see ahead. The earnings-reporting season about to begin looks especially dicey. According to FactSet Research Systems, 94 companies in the S&P 500 have issued negative preannouncements—just one shy of the record set in the fourth quarter of 2013.
Energy isn’t the culprit this time, however. Twenty-five information-technology companies top the negative-guidance list, followed by 18 consumer-discretionary and 17 health-care outfits, according to FactSet. Indeed, earnings warnings were running 50% above the five-year average in the last group, which may have had something to do (along with politics) with the negative 5.57% return of the Health Care Select Sector SPDRXLV in Your Value Your Change Short position ETF (XLV.)
But bulls needn’t totally despair. April is not the cruelest month for the stock market; exactly the opposite, in fact. Bespoke Investment Group’s numbers show that the Dow industrials bloom in April, with an average return for the month of 2.09% and positive returns 66% of the time. Over the past 20 years, the record is even better, with the Dow returning, on average, 2.6% and ending in the plus column 75% of the time.
A strong April typically starts the “sell in May and go away” chorus, and B.I.G. says that history tends to confirm the old saw. That said, a 5%-plus month (such as March, in which the Dow was up 7.08%) has been followed by a median gain of 1.3% the following month (and a positive showing 71% of the time) in the past 20 years. The following three months notched a median return of 4.54% and a positive return 74% of the time.
And the markets have the monetary winds at their backs. The dollar’s uptrend has been broken, which is positive for commodities and multinational U.S. stocks.
Of course, confidence is rising, as the decline in the VIX fear gauge to a somnolent reading just over 13 suggests. The first three months of 2016 should provide ample warning against complacency, especially as the U.K. votes in June whether to opt out of the European Union. And there’s also that small matter of the U.S. presidential campaign. Another roller-coaster ride, anyone?