One of These Days

Stocks returned to their winning ways in July with a 4.9% return. June, the month fraught with fears related to Federal Reserve policy, seems like ancient history after July’s robust performance. The S&P 500 has risen 10 of the last 12 months and is now up 19.6% for the year and 25% for the trailing 12-months. Stocks of all types (value, growth, etc.) are making new highs and have now definitively pushed through historical high-water marks set in early 2000 and late 2007. There is a good chance stock prices are in a secular bull market, and will continue to reach higher highs. Rising markets tend to attract investors as no one wants to miss out.
As good as things have been, this bull market is getting a little long in the tooth. All good things seem to come to an end. Bond market investors are nervously weighing the long-anticipated directional change in interest rates. It is not clear whether this will lead to stock market inflows. Investors remain skeptical of stocks, as measured by recent American Association of Individual Investors sentiment surveys.

There are a few other aspects to the current market that are making my job more difficult. First, the market is getting a little pricey. The S&P is now trading at a P/E multiple of approximately 14.6x forward earnings estimates (currently $117.13). This multiple is higher than at the start of the year and higher than the 12.9x 5-year average. The concern is that corporate earnings (and analyst earnings forecasts) are growing, but not nearly at the rate necessary to sustain the growth we have been seeing in stock prices. This is more a macro view and not a trading call, but the bottom line is the market as a whole is becoming expensive.
Second, short-term measures are overbought. A measure we typically review is the percent of S&P 500 stocks that are trading 1 standard deviation above their 50-day moving average. Today, 67% of the S&P is one standard deviation above the 50-day, while only 7% is one standard deviation below. On the whole, 2013 has been difficult. Like they are today, prices have been overbought for the duration of the year. June was the only true opportunity to buy stocks at “cheap” prices. For example, in June, the above percentages were nearly reversed. There were many stocks priced well enough to buy, and we did, but the window closed quickly.

Finally, the market is a hodge-podge of information. Typically, we analyze stocks based on like characteristics (factors) and their recent contribution to returns. Often times, for extended periods, the market will favor stocks exhibiting a certain characteristic (or characteristics). Some of the more common characteristics are measures such as high dividend yield, low P/E ratio, medium market cap and prior month’s returns. We assess how we want to weight our portfolios based on the characteristics of the stocks generating positive returns. At the moment, all stocks are rising and it’s difficult to attribute returns to any one or set of characteristics.
The potential camel in the tent is the market’s anticipation of a change in Fed policy. A true change in the direction of interest rates (shift in the yield curve) will have short and long-term implications. This has already made things difficult for most types of fixed income and also assets priced with some correlation to fixed income. The US 10-year Bond was 1.48% a year ago, 1.76% at year-end, and 2.6% today. The whole yield curve (beyond 1 year) has gapped higher. With no inflation to speak of and limited economic growth it’s difficult to see this continuing. I do not think the fundamentals support higher rates. It looks to me as though the market has priced in the end of QE3.

REITs and higher dividend yielding stocks also came under heavy selling pressure just as the yield on the 10-year made its dramatic surge beginning in May (60% bump in interest rates in a 3 month span). In my opinion, credit quality, and the integrity of the coupon are more important long-term considerations for income investors than near- term price volatility, particularly since the price volatility may be out of context with true fundamentals. I expect we have the option of being patient here. If we are truly entering a macro shift in the direction of interest rates, we will review your fixed income options and put an appropriate plan in place for you.
One of these days, things will change. It’s a matter of when. Until then, let’s review your asset allocation. If we have not spoken recently and you have any questions or would like to review your portfolio. In the meantime, please enjoy these long summer days!

Bruce Hotaling

CFA Managing Partner

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