Posts published in May 2014
The dominant media narrative in the wake of last Sunday’s European Parliamentary elections is the strong showing by an array of extreme, mostly right-wing parties. Consider the following smattering of headlines emanating forth from major media outlets this past week:
A Rubicon Moment for the EU? – New York Times, 5/29/14
The EU’s “Post Earthquake World” – Financial Times, 5/27/14
Chaos im Europaparlament? (Chaos in Europe’s Parliament?) – Frankfurter Allgemeine Zeitung, 5/27/14
This narrative is perhaps unsurprising. After all, many of the cultural attitudes and policy positions represented in these parties – France’s National Front, Britain’s UK Independence Party and Austria’s Freedom Party to name but three – evoke unpleasant memories of a not-sufficiently-distant past that the postwar European Union project meant to eradicate from the continent for once and all.
A fractured Europe would be a very undesirable outcome for the global economy – we got a taste of how undesirable during the 2010-12 Eurozone financial crisis. But we are not convinced that the reality in Brussels is quite as alarmist as some of the more provocative headlines would suggest. Let’s take a closer look at what happened, and what some of the larger implications may be.
It is indisputably true that radical parties had a good day last Sunday. The National Front and the UK Independence Party won the largest number of seats in France and Britain, respectively, and others posted strong showings in the Netherlands, Denmark, Austria and Italy. Voters in these countries clearly are not thrilled with the status quo – hardly surprising when Eurozone unemployment is stuck in double digits and job prospects in some areas are close to hopeless, particularly for young adults. But it is worth noting that, for the time being anyway, none of these radical parties holds sway at home. European voters tend to be more prone to vent their frustrations in Europe-wide elections than in their own national referenda. Recall that even in Greece, the sickest member of Europe’s struggling periphery, the citizenry voted to remain in the Eurozone when the question was put to them in 2012.
More Disputes Than Common Causes
Another problem the radical parties will face in trying to convert protest votes to action and influence is that many of them emphatically dislike each other. To be recognized as a political party group – basically a voting caucus – in the European Parliament requires a minimum of 25 legislators representing at least seven different nations. Marine Le Pen, head of France’s National Front Party, is trying to build such a coalition. But the UK Independence Party and the Danish People’s Party, two of the larger national movements, refuse to join in a common bloc with Le Pen and her chances of successfully forming one appear low. The levers of power – committee seats and chairperson plums and the like – are available only to these recognized party group caucuses.
The Center Still Holds
Meanwhile, the two traditional Project Europe-supporting party groups retained a majority (albeit diminished) of the Parliament’s 751 seats between them after Sunday’s vote. The center-right European People’s Party, which includes Germany’s Christian Democrats and France’s UMP, got 28% of the vote. The center-left Socialists and Democrats, dominated numerically by the German Social Democratic Party and France’s Socialists, hung onto 26%.
This is important from a procedural standpoint. The European Parliament does not initiate legislation, but rather is tasked with implementing the policies proposed by the European Commission. On large matters – including the economic and financial policy deliberations global investors would care about – the nuts and bolts of policymaking tend to revolve around committees dominated by German and French legislators hammering out and implementing a consensus approach with their Commission counterparts. With the current balance of power it is hard to see much changing in terms of the practical workings of Parliamentary norms and procedures.
La Question, C’est La France
If there is one wild card which merits keeping an eye on, it would be France. That France is the junior partner in the Franco-German hub of the European Union is not news to anybody who has paid attention to the Eurozone’s economic evolution. But French sentiment still finds it hard to come to terms with the idea that the European project is anything other than a socio-political enlargement of France itself. The voters’ mood is particularly sour: François Hollande’s ruling Socialist Party ran a distant third last Sunday to the National Front and the center-right UMP. Marine Le Pen in Brussels is far less scary a proposition than would be Marine Le Pen in the Élysée Palace.
But that is a worry for another day. Meanwhile, we expect little to change as EU policymakers deal in the coming weeks and months with the many pressing economic and financial issues calling for immediate attention.
2013 was a very good year for U.S. equities. Even more impressive than the 32% total return on the S&P 500 was the very low level of risk that accompanied it. Based on the Sharpe ratio, a widely-used measure of risk-adjusted return, the S&P 500’s 2013 performance was in a class by itself, far outpacing even the heady days of the late-90s technology bubble (see chart below). In the world of investment performance measurement, a Sharpe ratio above 3.0 is just about as close as you can get to having your cake and eating it too. Is low volatility here to stay, or is this just an unusual period of calm before the next storm clouds appear?
Not Much Fear in the “Fear Gauge”
In 2014 to date there have been pockets of risk, notably in certain small cap growth sectors. But the story in the broader market hasn’t changed much: subdued baseline risk with a few intermittent spikes when unexpected X-factors briefly flash onto the radar screen. The following chart illustrates this story. On the leftmost side we show the standard deviation of daily S&P 500 returns over rolling 30-day intervals. The right side presents the daily closing price of the CBOE VIX index, which reflects a weighted average of puts and calls on the S&P 500 over a range of strike prices. Standard deviation provides a useful picture of intrinsic volatility, while the VIX gives us a good read on market perceptions of risk; for this reason it is popularly known as Wall Street’s “fear gauge”.
Stuck in the Corridor
It is perhaps somewhat surprising to see this continuing pattern of low risk in the broad U.S. equity market. After last year’s big gains the market has mostly traded in a narrow and choppy corridor this year. Lack of direction can often mean heightened volatility. But apart from one brief spike during the late January pullback, the VIX has not even come close to breaching its lifetime average closing price of 20.1. Investors have largely taken in stride whatever the world has served up: from a harsh U.S. winter that impacted many corporate earnings results, to geopolitical turmoil in Ukraine, to a Eurozone flirting dangerously with price deflation. Support has been remarkably firm around intermediate moving averages, as the chart below illustrates.
Ready for a Breakout?
On the other side of the 50-day moving average support level, the index has several times bumped up against a psychological “round number resistance” point of 1900. At some point we would expect to see a directional trend form one way or the other; either a resurgent X-factor that brings back volatility and another pullback of 5% or more, or a continued rally driven by the meta-narrative of continuing benign economic data, double-digit 2H earnings growth and no new surprises from Ukraine, China or elsewhere. We need to be prepared for either outcome; that being said, the volatility signals are for the time being at least nowhere to be seen. “Sell in May” may not be a particularly helpful strategy this year.
On Tuesday this week the S&P 500 reached an all-time high, nudging past the psychologically important level of 1900. The broad market index has since pulled back, but remains above the 50-day moving average: indeed, it has maintained a positive distance from this intermediate support level for all but a handful of days after rebounding from the 5.8% pullback of late January – early February.
As the charts below show, there is an altogether different trend taking place in small cap equities. The S&P 600 Small Cap index is in correction mode – a pullback of 10% or more from the last high water mark – and is struggling to find support around its 200-day moving average. The market is split; the question is how it will un-split. Will small caps drag the broader market down into a second 5%-plus pullback, or will they find support and rally back sharply to catch up with the market? Or, as a third option, will this unusual split simply continue apace?
One distinguishing feature of the current market environment is that the bad news started with heavy sector concentrations. In particular, areas like biotechnology and Internet services suffered, with the S&P Biotechnology sector falling 18% from its February high to the low point in the middle of April. The impact of this sector-specific retreat has been more pronounced among small cap names than large cap.
What seems to have happened since mid-April is that the concentrated weakness diffused into a broader array of small-cap sectors while only minimally impacting the broad market. Both biotech and Internet services have firmed up somewhat since those mid-April lows while, as the above chart shows, the S&P 600 Small Cap index continues to set new post-February low points. And there has been attendant volatility in small caps that is largely absent from large cap equities. The large intraday spreads in the S&P 600 show a level of jitteriness out of sync with the CBOE VIX, the broader market’s so-called “fear gauge”, which remains close to the very subdued levels that have prevailed for most of the past one and a half years.
Janet Yellen, Stock Pundit
Last week small caps took a broadside from another, rather unexpected source. In a routine and otherwise largely unremarkable address to Congress on May 7, Fed Chairwoman Janet Yellen tossed out the observation – seemingly as an aside – that there are potentially “pockets of over-valuation” in small cap equities. Presumably Ms. Yellen will learn over time that seemingly innocuous phrasings – think “six months” or “taper” – can become dynamite when issued from the Valhallan heights of the Fed. Nor is the ensuing tempest necessarily short-lived, as illustrated by last year’s manic four-month climb in the 10-year yield after Bernanke’s initial tapering comments.
The Fundamental Picture
Moving averages, Fedspeak and the like are helpful tools for navigating the rapids from day to day, but we need to step back and look at the broader picture as we try to determine where the split market goes from here. Fundamentally, the theme of sustained economic recovery in the U.S. remains in our opinion largely unchanged, with the potential for a return to double-digit earnings as companies shake off the drag of the rough winter that impacted 1Q14 performance. Moreover, we would expect other risk factors such as geopolitical flash points and economic question marks in the Eurozone and China to have a less direct impact on domestic small caps than on the large companies with more international exposure on their financial statements.
Given the evidence at hand, with the obvious caveat that the immediate future is unknowable, we see a reasonable case to make for an eventual convergence of the split market without an undue level of pain for the broader market. A small cap overlay may be appealing for the tactically inclined, so long as one is mindful of the attendant risks.
Today’s Gen Y-ers are intuitively proficient at tapping into the cloud to glean wisdom from multiple sources. Friends, circles, people you have never met and never will meet, all can contribute to a steady drip-feed of insights about anything from where to get your hair done to the best place for Belgian mussels to how to brew India Pale Ale. So perhaps it is no surprise that one of the fastest growing trends in the investment world is a phenomenon known as crowdfunding. There is a growing movement bringing together entrepreneurs, intermediaries like angel investor networks, and the investing public. The SEC has weighed in with a proposed regulatory framework for crowdfunding, in response to legislation passed by Congress in 2012. For better or worse crowdfunding is part of the financial landscape now, and needs to be analyzed and understood.
The Wisdom of Crowds
Some years ago James Surowiecki, a social sciences author and commentator, published a book called The Wisdom of Crowds containing much of the philosophical view that informs crowdsourcing. One of the interesting cases in the book tells of studies conducted at county fairs in Britain some time ago. Fairgoers were invited to guess the weight of a particular livestock animal on display, such as a pig or cow. They would write down their guess on a piece of paper and put it in a jar with all the other guesses.
All the guesses by the passers-by were tallied up and averaged. The crowd’s average was then compared to the individual estimates of three livestock experts familiar with the physical characteristics of the animal on display. Almost invariably, the crowd’s average estimate was closer to the animal’s actual weight. As Surowiecki goes on to show in his book, this dynamic plays out in a variety of settings and subject matters. “Common wisdom” seems to be a real thing, not an oxymoron. Does common wisdom apply in the evaluation of investment opportunities?
Late last year the SEC released a proposed regulatory framework for crowdsourcing, including disclosure requirements, caps on issue amounts, marketing and communications guidelines for intermediaries, and anti-fraud protections. This has given rise to a new Wall Street acronym: PIPR (Private Issuer Publicly Raising). PIPRs are limited to a maximum issue size of $1 million for publicly crowdfunded deals. Separately, though, the SEC issued Rule 506(c) removing any marketing limitations at all for PIPRs if the target audience comprises accredited buyers only ($200,000+ in annual income and/or $1 million or more in investable net worth).
Much about crowdfunding remains to be studied and evaluated. There are clearly risks to be considered, and the opportunity certainly is not for everyone. But in an environment where traditional financial channels – bank loans and the like – are increasingly difficult for young enterprises to come by, the appeal of crowdfunding is obvious. And for investors interested in playing a role in the next generation of business growth stories, a sound regulatory and capital markets infrastructure for the dealflow may help to facilitate their involvement.
This has been an unusually busy week for the world of top-down investment analysis. Four headline events took place in the space of the past five days: the report on 1Q14 GDP, the Fed Board of Governors meeting, a release of the ISM manufacturing index and, to cap it all off this morning, the monthly jobs report. All of this alongside a steady drip-feed of corporate earnings to digest. How did we do?
At first glance the results would seem to be a mixed cocktail of numbers indeed, in particular, a much lower reading on GDP than expected, contrasted by a barnstorming jobs report. Truth be told, there are some green shoots and some dark clouds. But the overall take-away this week is a positive contribution to the economic recovery story. How the markets process it, of course, remains to be seen as the month of May evolves.
Jobs, Wages and the Labor Force
The headline jobs numbers were impressive. Non-farm payrolls added 288,000 new positions in April, and the unemployment rate fell to 6.3%. Growth was strong in business services and healthcare, but also in construction – perhaps surprising given talk of a slowdown in the housing market. Wages trended up by a little – 1.9% - but enough to stay slightly ahead of inflation. The big negative in the jobs report is the continued decline of the number of Americans participating in the labor force. 806,000 left the job market, sending the labor force participation rate down to 62.8% from March’s 63.2% - both low by historical standards. Even here, though, there was something of a silver lining. The long term unemployment rate fell as a percentage of the overall number of unemployed, with 287,000 new jobs for those who have been out of work for more than six months.
“Jobs Friday” is always a circus of pundits and pontification, but the earlier release of the 1Q14 GDP estimate drew far less curiosity. The figure of 0.1% was sharply lower than the consensus estimate of 1.1%, but observers replied with a shrug and two words: “harsh winter”. Buttressing that benign reaction was the higher than expected increase in the ISM manufacturing index to 54.9% from March’s 53.7%. Analysts following first quarter earnings results saw a bevy of decent results. With 372 S&P 500 companies reporting as of May 2 the average blended growth rate is 1.6%. Expectations just two weeks ago were that average 1Q14 earnings would be negative. Meanwhile, the Fed voiced its own confidence in the pace of recovery and continued with the QE tapering process.
The composite picture, in our opinion, is a good one. This does not mean, of course, that markets are certain to kick into high gear (thus far, reaction to the strong jobs numbers has been basically flat). But it appears increasingly hard to make the case for a serious drawdown threat. There are still plenty of X factors in the global economy and geopolitical landscape that could appear and cause problems. But our base case remains largely where it was at the beginning of the year: modestly positive performance with perhaps a handful of contained pullbacks.