June 1, 2012
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc., and
and Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and
and Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research
Key Points
- Equities have pulled back and are flirting with correction (-10%) territory. We believed this was a needed process, and remain modestly optimistic that economic data will rebound and the market will eventually resume its move higher over the next several months.
- The Federal Reserve has made clear that it stands ready to act should the US economy deteriorate, or the European debt crisis escalate, but we remain skeptical. The more important issue in our view is how the coming "fiscal cliff" is addressed.
- The European crisis continues to escalate and we are recommending that investors underweight European equities. Hopes of a sustainable solution in the near term are virtually nonexistent, while contagion fears are rising. China's growth has slowed but the country has tools at its disposal and we believe a soft-landing is the most likely scenario.
Frustrating! That's one of the most common words we hear from investors as they look at the current environment. Fixed income yields remain historically low, money market returns are nonexistent, international markets have various ills, and the domestic economy is muddling along—not a great list to choose from.
As uncertainty has grown, we are again reminded how important having a diversified portfolio can be. Day-to-day moves can be influenced by innumerable factors that are rarely predictable, and even over several months, markets can be influenced by exogenous events that are nearly impossible to appropriately factor into pricing models. For example, at what discount should equity markets trade if Greece exits the eurozone? We don't know if it will happen, when it might happen, how it will happen, or what the ultimate financial impacts may be. We don't know if there will be a relief rally or a sharp downturn on further uncertainty—both arguments can be made. And, of course, the market could move in the exact opposite direction if an agreement to keep Greece in the coalition is reached and viewed as credible by investors. As detailed below, risks in the eurozone have risen to the point that we are now recommending investors underweight European equities, which results in an underweighting of developed international, and use that cash to move to a potentially more defensive posture by investing in highly-rated US equities.
We continue to see signs, however, that many investors are overexposed to investments viewed as "safe." Highly-rated fixed income instruments continue to see near-record inflows and cash appears to be heavily weighted in many investors' portfolios. This "return of capital rather than return on capital" mentality, however, has its own dangers. By holding an outsized amount of a portfolio in these instruments that are paying next-to-nothing in yield, investors are virtually locking in losses of purchasing power at even a low inflation rate of 2-3%. To achieve investing goals over the longer-term, we believe investors need to be appropriately allocated among various asset classes, which may mean moving into areas that are not exactly comfortable and where clarity is lacking.
US looks good—relatively speaking
We believe that domestic equities are among the most attractive assets currently. We've seen a pullback that has come close to correction territory (down 10% from the top), which has helped to alleviate some of the overly optimistic sentiment indicators that we highlighted in early April. The American Association of Individual Investors (AAII) recently noted that its bullish reading is now at the lowest level in 20 months. The pullback has also helped to bolster the valuation picture as earnings remain healthy. In fact, on a forward-earnings basis, the multiple on the S&P 500, at 12, is four points lower than the long-term average of 16.
Economically, domestic data has been a bit soft, but several areas—notably autos and housing—have improved; and US growth is decidedly stronger that in many other areas of the world. The mild winter likely had an impact on data, and we are likely seeing a little give-back recently; but we think the risk of another recession in the near-term is low. Although unemployment claims are no longer descending at the same pace as earlier this year, the labor market continues to heal. The May labor report was disappointing but we don't want to panic over one or two weak numbers from a lagging indicator. However, the mere 69,000 jobs gained in May along with a tick up in the unemployment rate to 8.2% is certainly concerning and the next several weeks of data will be key to watch.
Claims have shown strength after soft patch
Source: FactSet, U.S. Dept. of Labor. As of May 31, 2012.
As noted, we've seen increasing signs that the housing market is slowly starting to heal. While its impact on the economy has dramatically fallen over the past several years, an even modestly improving market should help to bolster confidence and stimulate activity in various areas of the economy. The National Association of Home Builders confidence reading rose to 29 recently, still quite low, but the highest reading since May 2007. Additionally, we saw housing starts rise 2.6% month-over-month (m/m), new home sales gain 3.3% m/m, and existing home sales advance by 3.4%. Perhaps even more encouragingly, the median price of those existing homes rose 10.1% year-over-year. Finally, housing affordability remains at an all-time high thanks to still-low prices and record-low mortgage rates.
