To 1,500 and beyond?
It’s only the end of January and the market has already broken through our year-end S&P 500 Index target of 1,500. This doesn’t make us bearish, but it does make us cautious. We still expect equities to outperform bonds over the medium term, but shorter-term, it’s worth remembering that markets move in cycles of optimism and pessimism.
As investors have pursued their real goals, they have been riding in a risk-on/risk-off yoyo for the past couple of years where some of the biggest mistakes may have been buying on optimism and selling on pessimism. And although we don’t think there are indicators on investors’ dashboards currently flashing “SELL” there are warning signs reminding us that the near-term fundamentals look fully priced into current equity market levels.
We believe it’s important for investors to understand the factors driving optimism, but also the primary risk factors that could cause a reversal:
Why has the market run so hard?
- The U.S. avoided the “fiscal cliff” and there is confidence that the deadlines for the debt ceiling and sequestered spending cuts will also be successfully negotiated.
- The news on the U.S. economy has been positive. The housing market is continuing to recover and labor market indicators, such as weekly jobless claims, are improving.
- There has been better (or at least less bad) news from Europe. Bond yields have fallen to safe levels for Spain and Italy and a near-term crisis looks less likely.
- China is recovering. The manufacturing Purchasing Managers Index (PMI) is at the highest level in two years and most forecasters believe that a moderate recovery is underway.
- The fourth quarter U.S. corporate profits reporting season has so far been slightly better than expected.
What could cause a reversal?
- Failure to prevent large automatic government spending cuts. A deal was made to moderate the automatic tax increases in the U.S. at the beginning of the year and the debt ceiling deadline has been postponed to May 19. The main outstanding issue is the $110 billion (0.7% of U.S. GDP) of automatic spending cuts that were agreed to at the time of the debt ceiling debate in August 2011. These take effect on March 1, and although the recent tax deal delivered around 1.5% of GDP worth of fiscal tightening, adding on the full automatic spending cuts will take this year’s fiscal tightening to more than 2% of GDP. That’s enough to undermine the current confidence in the U.S. growth outlook. Even though investors have become used to politicians doing last minute deals and are complacent about the risks of a stand-off, the spending cut debate could be enough to unnerve markets and deliver a setback for U.S. growth expectations.
- More problems in Europe. Mario Draghi’s success in reducing bond yields across the euro zone has created a perception that the crisis is over. But this view is likely to be tested in coming months as economic data disappoints and sustained high unemployment creates social and political tensions. Fiscal austerity is ongoing and the European Central Bank seems unlikely to ease monetary policy further and euro strength is undermining export competitiveness. Although more positive of late, recent economic data releases point to ongoing recession and the Italian elections in late February will refocus attention on the euro-zone’s core problems.
- Earnings disappointments. The fourth quarter reporting season has started optimistically but the outlook for 2013 is at best lacklustre. U.S. corporate profit margins are high and forward indicators such as CEO confidence point to weak growth. Meanwhile the bottom-up consensus expects close to 10% EPS growth for the S&P 500® Index companies this year. Russell believes that overall profit growth of 5% would be a good outcome given that nominal GDP is unlikely to expand by much more than 4%.
- Over-optimism and complacency. Citigroup’s economic data surprise index, which measures how economic data matches consensus forecasts, has turned negative signalling that data releases are now failing to match more optimistic forecasts. The VIX index (which is a measure of investor fear) is at a five and a half year low below 13. Investors may be seeing few near-term risks and are becoming over confident about the economic outlook – a worrying combination.
We set our S&P 500® Index target of 1,500 in mid-December when the Index was around 1,425. We expected single digit returns from equity markets against a backdrop of moderate profit growth and reasonably full equity market valuation. Nothing that has occurred since then has changed our fundamental outlook.
The bullish case for equities involves moving back towards pre-crisis valuation benchmarks. S&P 500® Index is currently on a trailing P/E ratio of around 14.5 times1 compared to its pre-crisis average of 16.5 times. Returning to these levels will require confidence that the U.S. and Europe can return to their pre-crisis economic growth rates.
At a minimum, there would need to be a credible long-term plan to contain health- and age-related U.S. government spending, and Europe would need to create an effective banking union, a mechanism to share debt burdens across the region, and a strategy to end fiscal austerity and generate growth. All of these things are possible but none seem likely anytime soon.
Markets could also run higher if investors start allocating out of cash and bonds and into equities, especially those who missed out on last year’s rally and don’t want to miss out this year. This would send markets further ahead of fundamentals and create the risk of a larger pullback later.
So what does this mean for investors?
Our bottom line is that we think equity markets are fully valued and a lot of the upside risks have now been priced in. Markets move in cycles and there are enough warning signs to suggest investors are becoming overly optimistic. Longer-term, we expect equities to outperform bonds, but for now we are cautious about chasing the current rally. We want to avoid the traps of buying and selling on market sentiment in an ongoing risk-on/risk-off environment.
Andrew Pease is the Global Head of Investment Strategy for Russell Investments
1S&P500® Index trailing P/E ratio of approximately 14.5 is as of January 28, 2013.
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Manufacturing Purchasing Managers’ Index (PMI) is used to measure the level of diffusion based on surveyed purchasing managers in the manufacturing industry.
VIX is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 Index options. It represents one measure of the market’s expectation of stock market volatility over the next 30 day period.
The S&P 500® Index is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500® Index is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
Companies included in the index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor’s. The S&P 500® is a market value weighted index — each stock’s weight is proportionate to its market value.
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