Investors as of late have been heartily cheering the rally in US equities that (at least until today’s bad reaction to the latest job numbers) has propelled the Dow Jones Industrial Average and the S&P 500 into all-time record high territory. Now, it often happens that when the animal spirits are let loose to run rampant in the land of blue chip US equities other riskier asset classes – like small caps and emerging markets – do even better. Often, but not always. Given that the S&P 500 has settled above its 200 day moving average for 304 of the last 314 trading days, you might think this would be a terrific environment for a traditionally riskier play like emerging markets. Not this time.
Emerging equities markets seem to be inhabiting some other spacetime realm entirely. The MSCI Emerging Markets index is down by more than 3% for the year to date. That’s right – it’s in absolute negative territory, and on a relative basis that’s more than 13% worse than the performance of the S&P 500 over the same time period. What are we to make of this?
One school of thought leads to still-troubled Europe. Emerging economies have more at stake in selling their goods and services to Europe’s households and businesses. This is less about the Eurozone financial crisis and more about good old fashioned supply and demand. Those GDP growth rates that have been so impressive in recent years among emerging markets are predicated on robust export markets. But demand in Europe – for many EM companies the most important export market – remains soft.
In a broader sense, though, it may be more about winners and losers in the global economy. The “winners” plausibly could be emerging markets households and US businesses. Average household income levels in the emerging world continue to grow briskly, and with that growth naturally comes increased consumer demand. But who supplies that demand? When you look at the financial reports of large US companies you get a glimpse of the answer: a very significant portion of the earnings growth that has been so impressive of late comes from…yes, sales in emerging markets.
So even if economic prospects for the growth engines are still strong, the main beneficiaries may not be the companies that make up their stock indexes. If GE and Cisco Systems and Procter & Gamble are enjoying explosive earnings from their sales in China, India and Brazil, that doesn’t add direct value to the Shanghai Composite or the Bombay Sensex or the Bovespa. It adds direct value to the S&P 500 and the Russell 1000. And for the moment that value gap – in equity market terms – is in the double digits.
And what of the S&P 500? As of this writing the intraday level for the index is down by a bit less than one percent, in the aftermath of a slew of below-expectations job data. Well, the index had gained more than 10% for the year to date, and when that happens some kind of correction is usually to be expected. Whether it turns into anything more than a brief pullback remains to be seen, but at this point the data signals are not flashing emergency red. Patience and discipline are the watchwords.
Cyprus is a tiny country by most measures, with a population of just over 1.1 million. Most Cypriots who have local bank accounts hold well under €100, 000 in those accounts. They are Cyprus’s own 99%.
Russia is a very large country, with a population over 140 million. A tiny – but extremely influential – subset of that population also have bank accounts in Cyprus, most of which are very, very much larger than €100,000. Call them the 1%, who rose to the commanding heights of the statist capitalism that has defined Russia’s economy since the early 2000s. In this system Cyprus is a sort of combined Delaware and Cayman Islands – an address for moneyed Russian businesses to register office addresses and also to deposit large sums of the personal wealth of the individuals who run those businesses.
So if nothing else, this week’s tempest in the Eurozone has given us the rather awkward spectacle of the 1% and the 99% uniting under one banner, venting their wrath against the System. That system being, in this case, the European policymaking troika of the ECB, EU and IMF and their seemingly ham-handed efforts to impose a 9.9% tax on Cypriot bank accounts. These are the modest checking and savings accounts of the 99% and the opaque multimillion dollar holdings of the 1% alike. What have we learned this week – and what should we be worried about going forward?
We’ve learned that Russians tread carefully with a minimum of bluster when faced with the fear of losing lots of their hard earned (or ill-gotten) wealth. It’s hard to overstate the importance of Cyprus’s banking system for just about anyone in Russia with, say, more than $500,000 in personal liquid wealth. After some heated statements earlier in the week Russian Prime Minister Dmitri Medvedev has softpedaled, telling the Cypriot government to figure out their deal with the EU before expecting help from Russia. Putin himself has mostly remained mum. We imagine that a deal will be done – as we write this on Friday afternoon the parties are still locked in talks, with a variety of alternatives percolating up including a structure exempting small accounts, nationalizing the pension system or collateralizing future bond issues. World markets are taking the events in stride – US stocks have resumed their winning ways after a three day retreat earlier in the week. Market reaction is much more muted than in other Euro crises.
The other thing we’ve learned is that people really, really don’t like it when the Man shows up to take a slice out of their own personal (and mostly modest) fortunes. That’s a new tool to come out of the policymaking arsenal, and it looks to be a pretty bad one. What are the 99% thinking about now elsewhere along the Mediterranean coast – in Athens or Naples or Seville? Maybe they’ll come a-tithing for us – 10% here, 10% there – to maintain the sanctity of bank balance sheets and bond ratings. Very little could be more destructive than massive runs on the banking systems of troubled Eurozone economies. However the deal works out in Cyprus, the specter of the bank tax is now firmly and squarely in the policy mix. It’s something that policymakers may yet come to regret.
For several weeks now – really since the torrid pace of the January rally slowed to a more measured gait in February – market observers have spoken of the absence of a catalyst to move things more definitively in one direction or another. This week we got, if not a full-throated catalyst, at least a handful of reasons for investors to back off from recent highs and once again hold the S&P 500 at bay below the 1527 level it had finally surpassed this past Tuesday. The question is whether these past few days are indicative of a near term defensive crouch or whether the market will shortly resume its winning ways.
So what brought about the dour spirits? First of all, the release of the latest Fed minutes on Wednesday revealed a higher than average level of unease among policymakers about the potential ill effects of the QE3 program that has been going on since last fall. This program has been dubbed “QE4ever” by the market wags, and so anything that hints at taking the patient off the IV drip of easy money is bound to create some gloom. To add to the down mood a handful of signals came in showing Europe’s immediate economic prospects looking somewhat grimmer than expected. The latest GDP numbers show the Eurozone as a whole heading towards a 0.3% contraction this year as opposed to the 0.1% growth the European Commission had predicted at the end of 2012.
There’s little doubt that Fed stimulus and stability in Europe are key drivers for continued growth in equity indexes. However this week’s news didn’t seem to pack the kind of punch that could catalyze an extended downturn. After all there was no announcement that the Fed actually plans to curtail QE3 any time soon. The ECB’s “whatever it takes” stance is as much intact today as it was last week. More likely the mini-downturn (and the corresponding spike of nearly 20% in the VIX over Wednesday and Thursday) reflects the kind of tentativeness about which we have spoken in previous posts when indexes flirt with long term resistance levels. The S&P 500 is still well above its 100 and 200 day moving averages and is trading generally higher as the week draws to a close.
One thing to keep an eye on as February draws to a close is whether the latest Kabuki matinee in Washington spills over into market sentiment. The unfortunately named sequestration involving deep spending cuts across vast swaths of the budget appears likely to come into effect shortly. Lawmakers on both sides of the partisan divide appear to be far away from anything remotely resembling a deal. That doesn’t seem to be making much of an impression on the markets, but the fact is that if all the cuts go ahead as planned there will be an economic impact. Presumably investors, having seen this elaborate pantomime play out over and over again, assume that something will take place to prevent – or at least forestall – a worst case outcome. We will see how the sentiment tracks as the hour approaches.
Will there be a party? Probably not – 1527 is not the S&P 500 all time high water mark. But it is a significant milestone for longtime market observers because it was the peak achieved during the technology bubble; to be specific, the closing price of March 24, 2000. Putting that milestone behind us for once and for all would at least merit a glass of Veuve Clicquot, if perhaps not a truckload of cases of that fine eau de Champagne. It is most likely only a matter of time until we reach it, with today’s (2/13) intraday high breaching 1524 before settling back to close just above 1520. But it could be awhile before we wave goodbye forever.
Animal Spirits or Defensive Crouch?
Of course the S&P 500 is only one index, and it doesn’t move in a vacuum. As this broad US equities benchmark has rallied since the beginning of the year how have other asset classes fared? Relative movement patterns between a blue chip index like the S&P 500 and other benchmarks can act as a sort of sentiment gauge. Strong relative gains by asset classes like small caps or emerging markets can act as a market sentiment gauge. When exposures like small caps or emerging markets perform relatively better than the blue chips it can signify an uptick in animal spirits – a willingness to push out the risk frontier. Conversely, when a defensive sector like utilities outperforms it can imply a more cautious, defensive sentiment.
With that in mind what does the data tell us today? Well, something of a mixed bag actually. The Russell 2000, a popular small cap benchmark, has outpaced the S&P 500 by a bit more than 1% since the start of the year, though in the last couple weeks sentiment has been slightly more in favor of the blue chips. On the other hand the MSCI Emerging Markets index has substantially underperformed the S&P 500 over the same period, and is barely in positive territory for the year to date. Developed non-US indexes like the MSCI Euro and MSCI Pacific ex Japan are likewise lagging the S&P 500. Meanwhile the Dow Jones Utility Average, a traditional defensive haven, underperformed the S&P 500 during the torrid January rally but has since been steadily gaining ground in relative terms.
All of which is to say that there is not a compelling case to make for animal spirits run rampant, nor is there solid evidence of an imminent defensive crouch. None of which is unusual when a major market index like the S&P 500 hovers around a macro trend barrier. The high frequency trading platforms that dominate day-to-day volume are programmed to advance and hedge, advance and hedge, not unlike a tactic one might encounter in Carl von Clausewitz’s timeless military strategy classic On War. Directional allocation calls (e.g. on small caps or utilities) are tough to execute when the ground is constantly shifting underfoot. A better approach may be to stay nimble, with one foot further out the risk frontier and one foot closer in, until a yet to be known catalyst moves things more decisively in one direction or the other.
As of the February 6 close the S&P 500 was about 6% higher for the year to date in terms of price appreciation. The Dow Jones Industrial Average was ahead by 6.7% for the same time period. Interestingly, both averages are very close to their all-time high water marks. And both are flirting with big round numbers; the S&P 500 oscillates around the 1,500 mark while the Dow plays footsie with 14,000. It may sound silly, but historical patterns show that these big round numbers actually can be formidable support or resistance levels. Call it irrational investor psychology – but that’s what the numbers say. So at this juncture a few questions are in order. Does this rally have the legs to carry us into macro growth market territory? What are the risks that could keep things lurching along around these resistance levels for awhile? Could things get really bad again – are investors too blithely complacent about potential X-factors that could send things heading sharply south?
Those all-time high water marks (14,164 for the Dow, 1,565 for the S&P 500) are fueling lots of chatter about the so-called “Great Rotation” – a structural shift from fixed income into equities. One could ask, is the Great Rotation any more real than the Great Pumpkin of “Peanuts” fame? Perhaps. Or perhaps not. The bulls point to the $11.3 billion net inflows that came tumbling into US equity funds in the first two weeks of 2013. That’s the biggest fortnightly inflow since April 2000. The bears say…yeah, April 2000. Remember what happened after that? Ouch.
But market conditions today are hardly like they were in that last dizzying month of the dot-com bubble. Equity valuations are much more modest – maybe not screaming bargains but not wildly overpriced either. And, lest we forget, the yield on the 10-year Treasury was over 6% in the first quarter of 2000. If anything could drive frustrated yield-seekers out of bonds and into equities, then the fact that in inflation-adjusted terms you actually have to pay to own the 10-year Treasury – surely that should be at the top of the list of reasons, no?
Great Rotation or not, we do believe that the landscape looks reasonably promising for equities in 2013. But we also don’t think it’s going to be a one-way joyride upward. The market still moves more to the utterances (or non-utterances) of Ben Bernanke or Mario Draghi on any given day than it does to factors more directly pertinent to the business value of the companies that make up the indexes. The 10-year yield is still mostly below 2%, meaning that any Great Rotation money that’s out there still has one foot planted in the bond market while it gingerly treads further into equities. And brisk rallies like the one we’ve seen since the beginning of the year – especially when contending with macro-trend resistance levels – are vulnerable to significant corrections before they finally succeed in scaling the wall. We have to be prepared for perhaps a bit more volatility than we’ve had to deal with for awhile.