Stocks opened 2013 in impressive fashion. The S&P 500 Index gained 5.2% in January, delivering a sizeable share of the total return that a number of investment firms, including our's, projected for the whole year. Bulls are taking comfort that central bankers have, for at least the past 12 months, mitigated the risks associated with potential deflation and deleveraging. Bulls are also citing the U.S. housing recovery, discussed in the January 22, 2013 edition of Market Notes, and the robust economic activity tied to U.S. oil and natural gas production. Bears note that "the smart money" is selling—ratios of corporate insider sales to purchases, for example, have risen materially—while surveys of retail investors, ostensibly representing the "less sophisticated money," reflect significant improvements in sentiment. Inflows into equity mutual funds in January were robust. The market is likely due for a breather as a number of technical indicators—including the relative strength index, which compares the average magnitudes of gains and losses over a given period—suggest an overbought market.
Super Bowl result a market jinx?
Will the result of Super Bowl XLVII derail the bull market? Because the Baltimore Ravens are considered an American Football League (AFL) team, their victory implies a negative year for the market. If an old-line NFL team wins, which occurred in 33 of the first 46 games, the market is supposed to rise for the year. If an AFL team wins, the market is supposed to decline. The "Super Bowl indicator" has a 76% success rate; by simple chance, it should be correct perhaps 60% of the time, reflecting the portion of rolling 12-month periods in which stock prices have climbed. For what we hope will be a more prescient view of 2013 we turn to corporate earnings and stock valuations.
Earnings growth continues halfway through earnings season
As of February 1, 239 of the S&P 500 Index companies had reported their fourth-quarter earnings. The blended fourth-quarter earnings growth rate—reflecting both reported results and expectations for companies yet to report—stands at 3.8%, an improvement compared to the 2.8% estimate on January 1 but a material decline from the 9.9% growth rate that was anticipated on October 1. For 2013 as a whole, the consensus earnings growth estimate of typically optimistic bottom-up analysts—those who build forecasts company by company—is 8.4%, while top-down strategists—those who build forecasts for companies in aggregate, based on economic expectations—are projecting a more reserved 4.9%. S&P 500 company earnings can grow faster than the U.S. economy thanks to corporate sales in emerging markets, but we believe it will be difficult for earnings to significantly outpace the expected nominal U.S. growth rate of 4.0%.
Forward multiple expands, awaiting critical increases in business investment spending
The two key ingredients to future stock prices are the earnings growth rate and the amount investors are willing to pay for each dollar of earnings, also known as the earnings multiple. The forward 12-month multiple for the S&P 500 was 13.3x as we exited January, slightly above the 13.1x average since the Great Recession began in December 2007. Our perspective is that business investment spending needs to materially increase in order for multiples to expand significantly from current levels. We believe the supply side of the economy is key to breaking out of the current slow-growth malaise, as investment spending has tended to precede personal income and employment growth. It is unlikely that either the gap between potential and actual economic growth or the under-employed labor force issues will be cured by monetary stimulation alone. Unfortunately, it appears that many corporate treasurers are content to seek to reward shareholders with increased dividends and share buybacks. Missing is a material expansion of the overall market for goods and services. We will carefully monitor business investment spending as one guide to future changes in our model asset allocation strategies.
Japan joins the competitive devaluation game
The results of Japan's late December 2012 elections continue to reverberate globally. The new Liberal Democratic Party (LDP) government under Prime Minister Shinzo Abe is working on a new debtfinanced infrastructure spending program. Abe has placed pressure on the Bank of Japan to adopt a more expansionary monetary policy. While the bank yielded to the government on a 2% inflation target, it has defied the government on "quantitative easing," deferring an expansion of asset purchases until 2014. Thus far, "Abenomics" have produced a significant depreciation of the yen and have boosted the Japanese equity market. The new policies likely also have contributed to rising global stock markets. The Japanese yen had been a relatively strong currency, especially since the euro zone debt crisis. However, with the yen depreciating, the risk of competitive currency depreciation, or "currency wars," is rising. China is watching Japan warily, not just because of the competitive impacts of yen depreciation, but because Abe is likely to take a more nationalist stance over disputed islets in the East China Sea. The new Chinese Politburo Standing Committee under Xi Jinping is beginning to formulate economic policies. In the meantime, the Chinese stock market has been recovering, as have a number of Chinese economic indicators. With the risks of a "hard landing" subsided, China is aiming now for more sustainable growth of 7–8%.
European conditions improved but investors need to remain alert
Since last fall, yields on Spanish and Italian sovereign bonds had been falling, given a pledge of reformcontingent support from the European Central Bank. However, in recent weeks, concern has arisen over political developments in Spain and Italy. First, a prominent Spanish newspaper published accounts of bribery involving Prime Minister Mariano Rajoy's pro-reform political party. Rajoy has denied the charges, but if there is substance to the allegations, Spanish reform efforts could be undermined. Further, chaos in Madrid could embolden Basque and Catalan separatists to announce independence referendums. In Italy, where elections take place on February 24–25, a coalition led by anti-reform former Prime Minister Silvio Berlusconi has gained in the polls and is now a few percentage points behind the leading Democratic Party. It remains likely that the Democratic Party will form the new government, in partnership with a coalition of minor parties assembled to support Mario Monti. We may witness another round of instability in coming weeks. However, we do not expect reforms to be unwound.
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