Friday’s report was disappointing. A net gain of 120,000 jobs with no prior month upward revisions is bringing back the idea of a mid-year slowdown, much as we saw the last two years. Bonds reacted very favorably, figuring the Fed would have to take action. Stocks went the other way on Monday (Tuesday’s losses were Europe-related). One should not read too much into one month’s report, for the trend is still intact. If nothing else comes out in the next week to corroborate the slowdown in hiring, the markets will shrug it off and wait for the first week of May.
The S&P 500 gained more than 30% between October 3, 2011 and April 2, 2012.[i] We believe this rally is tired and needs to consolidate. New money should be patient, as it is almost certain to be given a better entry level. Even after the recent 4% pullback.
Stocks are not cheap anymore. Over the past three years stocks have been available at a discount. That seemed appropriate, as circumstances (a collapsed real estate market, high debt relative to GDP in most of the industrialized world, and a potentially shrinking government sector) suggested that economic growth would be lower than average this cycle. Investors did not want to pay the average market multiple if profit growth was going to be below average. Well, as is turned out, profit growth has NOT been below average. There are a variety of explanations for this, but the bottom line is that corporate earnings have done better than expected, and investors have finally given in and priced stocks accordingly. Now many stocks trade at prices that assume this robust profit growth will continue. When expectations are low, “risk” (the chance that the expectations are wrong) tends to be to the upside. Now that expectations are fairly high, there is more downside risk than upside.
Not a day goes by that somebody does not warn investors that bonds are in a bubble and that soon bond yields will soar and bond prices will plunge. And about every six or eight weeks a report comes out that spooks bond investors and yields do in fact soar and prices do plunge. And then that move is completely reversed in the next week-and-a-half. Bonds are in a trading range. Betting on breakouts from that range have been surefire ways to lose money (especially betting that rates will break out on the upside). Bonds are not attractively priced, but that has been the case for 18 months. Investors have earned middle single digit total returns on intermediate duration investment grade bonds and may continue to do so (maybe 3-5% versus the previous 4-6%). Today’s environment modestly favors credit spread bonds (high yield corporates and emerging markets), but those sectors have seen a lot of inflows recently so caution is warranted.
Still #1 in terms of what could go wrong and really hurt the stock market. Greece is a known and has little potential at this point to cause meaningful harm. Spain and Portugal are the countries the market is worried most about now, because problems there are only slightly discounted in current prices. A lot of debt comes to market this month. The powers-that-be in Europe have been impressive so far in their resourcefulness, but when you cannot grow fast enough to meet your obligations eventually the money dries up. The Euro dropped 2.3% last week. Expect this month to be eventful. Continue to be underweight.
Growth is slowing but so is inflation. China is trying to manage a slowdown in its economy because inflation and real estate speculation had been getting out of control. If their official statistics can be relied upon, China has been fairly successful. However, this slowdown has had a negative impact on the global materials sector, which for years has been driven by Chinese demand. The concern here is not just economic (in that which will slow faster, inflation or economic growth), but political in that later this year the Chinese Communist Party elects a new set of leaders. One can only guess at the impact of those changes at this point, but markets don’t like uncertainty.
Investors currently exhibit a strong preference for growth stocks over value stocks.
Last quarter the difference was 7.5% (16.7% versus 9.2%, according to Morningstar). Moreover, the preference for earnings momentum stocks over growth-at-a-reasonable price was staggering. The former gained more than 21% in the first quarter while the latter rose just 10%. What is even more surprising is that the earnings momentum leaders, stocks like Apple, Chipotle, Salesforce, Starbucks, and Tractor Supply, have actually lost less this month than have growth stocks with lower earnings multiples. Generally, one would prefer to see stock price gains being more broadly distributed than being largely contained in a narrow group of names.
Past Performance is no assurance of future results
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[i] Data retrieved from Telemet Orion and calculated based on closing prices.