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On the Market Schwab Market Perspective: Bull/Bear StandoffLiz Ann SondersSenior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc., Brad Sorensen CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and Michelle Gibley CFA, Senior Market Analyst, Schwab Center for Financial Research July 30, 2010 Key points
The standoff between the bulls and bears continues and the market remains relatively rangebound. Numerous other standoffs have contributed to this situation as austerity proponents battle Keynesian enthusiasts, the Federal Reserve tries to entice borrowers, small businesses maintain a much different outlook on the state of the economy, and technicians of all stripes argue about various indicators. This uncertainty has led to rangebound action, resulting in some of the highest correlations among stocks ever seen, according to Ned Davis Research's 63-day correlation measure. The end result of all of this is a potentially difficult and challenging investing environment. We remain relatively optimistic, but want to remind investors that having a static and dogmatic view without heeding the call of new information can result in being dogmatically wrong. As always, we strongly recommend viewing stock investments over a reasonably long time horizon. Money you might need in the short-term shouldn't be invested in stocks. Recent action has investors putting more emphasis on technical analysis. We do look at technicals, but not exclusively, as the historical evidence of the accuracy of most technical indicators is spotty—and when effective, they tend to be shorter-term in nature. One example was the recent media attention on the "death cross" or "dark cross" that occurred in the first part of July—when the 50-day moving average fell below the 200-day moving average—supposedly indicating a pending and sustained downturn in the market. Historical evidence, however, is shaky, given that during the 28 death crosses in the S&P 500 since 1930 (involving a falling 50-day moving average and a rising 200-day moving average when they crossed) showed a very mixed record. In fact, the market was actually higher three months later in 16 cases. The lesson is to pay attention to technical indicators as potential points of entry or exit, but to use such analysis with caution. Investor sentiment has a better historical record than many technical indicators. Unfortunately, individual investors tend to be good contrarian indicators—meaning stocks tend to rally after sentiment reaches extremely pessimistic levels, much as we saw to start July as the S&P rallied nearly 7% in a two-week period. Sentiment had been crushed thanks to the 16% correction that began after the April market highs. You can try to use this to your advantage in this environment as we shift between pessimism and optimism by adding to positions as needed during periods of extreme worry and doubt, and reducing stock allocations as appropriate during times of extreme optimism. Earnings season and economic data leave questions Second-quarter earnings season has been largely positive, with the market rallying, although there was still uncertainty surrounding corporate outlooks. For the most part, profits were good and beat expectations as companies continued to hold down costs and are generally seeing demand improving—especially over the year-ago period. However, revenue results among some companies left something to be desired, as estimates were missed. This fanned some concerns that the economic recovery was fading, and demand for goods and services was falling off. Recent economic releases did little to clear up the picture, but largely remained supportive of our view that the economy is entering a slower, steadier growth phase. Retail sales (excluding autos and gas) rose 0.1% in June, slightly better than expected, while industrial production also improved slightly. Additionally, both the Philadelphia Fed Manufacturing Index and the Empire Manufacturing Index (regional surveys that provide a preview to the national Institute for Supply Management Manufacturing Survey) moderated, but remained in territory depicting continued economic expansion. Finally, housing data remained murky as the market continues to stabilize from the expiration of the federal tax credit. Housing starts fell again, largely due to more-volatile multi-family structures, while the forward-looking building permit number actually rose 2.1%. Pricing continues to firm up relative to a year ago, with the Case-Shiller index showing gains of nearly 5%. We believe future months' housing data will give us a "cleaner" read on the market as we get further away from the tax-incentive period. Conflict in Washington, while Fed remains flexible Uncertainty regarding future government actions remains as one of the elephants in the room for the market. Experts continue to argue about the effects of the stimulus package, of which about $480 billion has been spent (according to the Council of Economic Advisors) to mixed reviews, with the remaining $307 billion yet to be spent. Debates about whether to extend tax cuts on everything from income to dividends to capital gains unnerve investors and businesses, while the recent passage of health care reform and the financial regulatory bill raises concerns that costs for all types of businesses will be increasing. In fact, in the latest National Federation of Independent Businesses (NFIB) survey, small businesses showed reduced optimism, citing concern over increased government involvement in the private sector as one of the major reasons. Small business optimism needs to improve  Click to enlarge Source: FactSet, Federal Reserve as of July 27, 2010. Small business is vital to the continuation of the economic expansion, as that's where a majority of hiring is expected to come from. Continued cautiousness will likely result in continued disappointing job growth. The Fed is also dealing with confidence issues. It has flooded the market with money and made it explicitly clear that the fed funds rate will remain near zero. However, that money is not working its way through the economy as had been hoped. Between tighter lending standards among financial institutions and cautiousness among businesses, the money multiplier remains extremely low, blunting the effectiveness of the Fed's policies. Money not working its way through the economy  Click to enlarge Source: FactSet, National Federation of Independent Business, as of July 27, 2010. As a result, the Fed has been discussing possible options should deflation become more of a concern. Fed Chairman Ben Bernanke's recent Congressional testimony indicated that the Fed doesn't plan to embark on a renewed round of quantitative easing at this point in time, but is keeping its options open. European bank test "not so stressful" Mimicking a process already completed in the United States, European regulators put their banks through "stress tests" in an effort to determine the stability of the sector. Similar to some US cases, the European bank stress tests were criticized as not having been stringent enough. Critics complained that they failed to reflect the possibility of a government debt restructuring and lacked details on foreign household debt holdings. A surprisingly low seven banks failed, having a capital deficiency of 3.5 billion euros ($4.6 billion). However, with the exception of several German banks, the results provided more transparency than expected. In particular, country-by-country sovereign debt holdings in both the trading book (short-term holdings) and banking book (held-to-maturity holdings) provided investors the ability to make their own assumptions and test the strength of the banks. According to Citigroup, if losses on sovereign debt were included on the banking book, 24 banks would have fallen below the 6% Tier 1 capital ratio threshold, with a combined capital deficit of 15 billion euros. This is much lower than estimates that ranged from a 40 billion euro to 100 billion euro deficit, and demonstrates that the European banks are better capitalized than expected, primarily because the banks raised more than 200 billion euros in capital during the past 18 months. The tests were successful in removing a layer of uncertainty and may alleviate concern about the interbank lending market freezing up, which could overflow into the general economy and slow overall growth. Near-term bank sentiment also benefitted after the Basel Committee softened proposed rules on global bank capital, which would have resulted in required increases in capital under the prior proposal. Lastly, European economic data has been better than expected, exemplified by the euro-zone manufacturing and services Purchasing Managers Indexes increasing in July and German industrial orders unexpectedly rising. European economic forecasts have been cut recently, and it's possible that the easing of bank pressures could result in upward revisions to European growth forecasts. The euro could have more upside in a "relief rally" and has likely seen its near-term low. However, excessive pessimism has been removed, and the euro seems unlikely to move significantly higher. European government debt auctions continue to experience indicate diminished anxiety, with yields and spreads over the benchmark German bund falling. European debt fears waning  Click to enlarge Source: FactSet, iBoxx, Tullett Prebon Information, as of July 27, 2010. However, sovereign debt risks remain and will likely continue to flare up. Greece's compliance with International Monetary Fund rules regarding its country's finances will be reviewed during the next few weeks to qualify for August 30 disbursements. The ability for governments globally to execute reform measures will continue to contribute market volatility. Chinese economy slowing but market outlook improving Economic growth is decelerating in China, with second-quarter gross domestic product growth of 10.3% (below the 11.9% year-over-year rate in the first quarter), driven by a moderation in manufacturing. There are indications of further slowing to come, as slower imports in the second quarter point to weaker exports later (because many imports are production inputs for future exports) and as year-over-year growth comparisons get tougher. However, growth is still above the government's 8% target, and there's no compelling reason to tighten or ease currently; this enables the government to take a "wait and see" approach and maintain flexibility. The prospect of tightening likely precipitated the decline in the Shanghai Composite in mid-2009, as markets are forward-looking. Additionally, the index is down 20% in 2010, working off 2009's speculative activity, and liquidity declined as capital raising created competition for investor funds. China begins to outperform as liquidity eases  Click to enlarge Source: FactSet, Shanghai Stock Exchange, Standard & Poor's, as of July 27, 2010. Note: Indexed to 100 as of July 27, 2009. Liquidity started to improve after trading began July 15 for Agricultural Bank of China Ltd., the world's biggest initial public offering (which raised more than $19 billion) in four years. Fund raising and additional IPOs will continue, but the completion of this outsized transaction is notable. Additionally, policy measures have begun to lean away from tightening, with the announcement of stimulus measures such as infrastructure spending in western Chinese territories and initiatives for clean energy and a property tax reported to be pushed out until 2012. The Chinese government initially targeted the property market, aiming to slow price appreciation. The culmination of measures by mid-April nearly halted sales in May and prices began to fall. In response to isolated cases of 20% price discounts, media reports noted a "rush of buyers." Home sales in China continue to fall in July, though at a slower pace. Prices are likely to decline given that a surge of supply is forecasted to come to market in the coming months as projects started more than nine months earlier are completed. As a result, the government could have less reason to deploy measures to moderate prices. For more discussion, see Country Focus: Does China Have a Japan-Style Bubble? The bear case in China has shifted to Chinese local governments (which receive funding through financing vehicles) being unable to directly issue debt. The concern is that local government-financed projects are not generating enough cash to pay back loans and could default. Bank balance sheets would be threatened by rising delinquencies, although current readings on non-performing loans are currently low. If banks' ability to issue credit was to become impaired, this could further slow economic growth. There are no guarantees, but the belief is that the central government would step in to prop up the banking system, the majority of which is state-owned. On balance, we're becoming more optimistic on prospects for the Chinese stock market as a whole, while monitoring bank lending trends. Quest for differentiated growth Emerging markets have been outperforming developed markets due to their better growth prospects and generally lower levels of government debt. The path of the global economy is uncertain, but India's economy has the potential to grow even if the global slowdown persists (see Michelle Gibley's Country Focus: India's Growth Shines). While Indian stocks could pause with rate hikes, India has a young and growing workforce, rising income levels and a domestic-driven economy. Risks to growth in India include inflation, inadequate infrastructure and the need for government reform. Important Disclosures The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey. The S&P 500® index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly. Past performance is no guarantee of future results. Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks. The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (0710-4899) Return to Top |
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