The rally we love to hate.
Market rallies can be the stuff that try investors’ souls. On the surface, rallies are good news, but look deeper and you’ll find investors filled with uncertainty over how long the rally will last or whether the bottom might fall out altogether. The uncertainty then leaves investors forced to hesitatingly dip their toes into the market waters (or wade deeper) as prices grind higher. The current rally—which began in the middle of February when the S&P 500 started its nearly 20% ascent—is both heated and hated. It has simultaneously taken us to all-time price heights and amplified the usual rally trepidation.
Why is the current rally so reviled?
On many recent occasions, we have noted our concerns over an earnings recession. Results for the second quarter appear to be headed for another year-over-year decline this time in the neighborhood of 3%, with positive comparisons not expected until the fourth quarter of this year. Looking at the next 12 months, however, earnings optimism abounds. The S&P 500 is trading at 17.1 times the forward 12 months earnings (P/E ratio), which is well above the recent average and toward the high end of the range (Figure 1). Earnings are expected to grow 13.6% in 2017 which appears to be very (perhaps overly) robust considering the difficulty we have had in developing any sort of growth in the past few years. Given this, there seems to be a lot of hope surrounding the most fundamental factor: corporate earnings. While we sometimes question if it is enough to power a major earnings expansion, the underlying growth in the U.S. economy provides a backdrop to our core narrative which supports further growth particularly around consumer spending—the highlight of the recently released 2Q GDP data. The paltry 1.2% gain in overall GDP is not as bad as it may initially appear given the strength of consumer spending, but the lack of growth in business spending remains puzzling and is something we will continue to watch carefully.
Contrary to our concerns from a fundamentals perspective, technical factors are firmly supporting the market—in particular, the highly accommodative stance being taken by central banks. Our Federal Reserve just decided to once again leave rates steady while opening the door a crack on a September hike. More than likely they will leave this decision until December, echoing the end of last year. With two rate hikes likely spanning a year’s timeframe, the Fed is clearly reinforcing the view of many that it will remain “lower for longer.” Accommodation extends well beyond U.S. markets, where central bank balance sheets continue to grow (Figure 2). These purchases, combined with over $12 trillion in sovereign debt yielding less than 0%, have created incentives for global investors to pour money into our markets in the search for any sort of positive yield. This has helped to lower Treasury yields, narrow corporate bond spreads, and raise prices on dividend-paying stocks. Both the Bank of Japan and the European Central Bank will contribute to further balance sheet additions, thus expanding their accommodative positioning.
We find ourselves stuck between fundamental factors that have yet to prove themselves and technical factors in which central banks appear to be intent on keeping asset prices highly valued. Some might say that this has the making of a “bubble” and they would probably be right if earnings fail to materialize and the central banks start tightening. However, the earnings story has months to play out and central bank accommodative policies are not likely to go away anytime soon. Look for the rally—and our love-hate relationship with it—to last a while longer.
Positioning shift for emerging markets
One arena where we think fundamental factors are in play and turning favorable is in emerging markets (EM). We have maintained an underweight position in this space since September 2013 but our Investment Committee (IC) voted this month to start moving portfolios closer to a neutral weight relative to our long-term strategic asset allocations.
The IC has been monitoring EM improvement and focusing on several potential tipping points we’d need to see before considering any trades. These included a Fed that’s unlikely to raise rates aggressively and indications that Chinese growth was stabilizing. As mentioned above, indications are the Fed will remain “lower for longer” and even if it raised rates in September or December, there is little reason to expect it would be the first in a series of further hikes. While concerns about China (the largest EM by equity market capitalization), are still likely to flare up occasionally, the government appears to successfully be managing any issues and limiting downside risk.
In addition to the just-mentioned triggers, we considered a number of other supportive factors. Outside of China, there appears to be building a fairly broad base in support of EM growth. Also, the largest companies in the EM indices are shifting toward “new” economy-based firms. As we noted in our Capital Markets Forecast commentary, “The wheat from the chaff: obstacles and opportunities,” emerging countries were likely to transition from basic and commodity-centric firms toward those engaged in retail services and technology. We are seeing growing evidence that this is taking place. Looking closely at Asian technology stocks, broader EM telecom stocks, energy stocks, and Brazilian financials, they are making significant return contributions. We believe these particular equity drivers are not transitory and that they will persist and grow.
Large-cap sector adjustments
Finally, we have made some small adjustments to our Wilmington Trust Sector Allocation Strategy®, removing underweights to the consumer discretionary, energy, and telecom sectors. We have also adjusted weights in healthcare and industrials to account for the movement of Danaher (designer and manufacturer of medical, industrial, and commercial products) from industrials to healthcare. We are taking up a slight overweight to energy, based on the improving supply and demand balance into 2017 as the U.S. rig count declines. Improvements in valuation metrics supported additional weights to telecom and consumer discretionary.
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Formerly the Lehman Aggregate Bond Index, this index tracks investment-grade bonds traded in the U.S.; the securities are weighted according to their market size.
Citigroup Economic Surprise Index
A measure for various regions, which shows how economic data are progressing relative to consensus forecasts of market economists. The weighted, historical standard deviations of data surprises are calculated daily in a rolling three-month window. A positive reading suggests economic releases have on balance been beating consensus estimates.
Dow Jones Industrial Average
Index that shows how 30 large, publicly owned U.S. companies have traded during a standard trading session in the stock market.
HFRX Global Hedge Fund Index
One of the family of 75 HFRX Hedge Fund Indexes, the global industry standard for performance measurement across all aspects of the hedge fund industry.
MSCI EAFE Index
Largely recognized as the preeminent benchmark in the U.S. to measure international stock performance; it comprises indexes that represent developed markets outside of North America: Europe, Australasia, and the Far East.
MSCI Emerging Markets Index
Designed to measure stock market performance in the global emerging markets; it covers over 800 securities across 23 markets and represents roughly 13% of world market capitalization.
NASDAQ Composite Index
Index of common stocks and similar securities listed on the NASDAQ Stock Market Index, which has over 3,000 components. The Composite is considered an indicator of stock performance for technology and growth U.S. and non-U.S. companies.
Used to evaluate the likelihood of default by a bond issuer. Independent rating agencies analyze the financial strength of each rated issuer. Moody’s ratings range from Aaa (highest quality) to C (lowest quality). Bonds rated Baa and better are considered “investment grade.” Bonds rated Ba and below are “speculative grade” or “high yield.” Similarly, Standard & Poor’s ratings range from AAA to D. Bonds rated BBB– and better are considered “investment grade” and bonds rated BB+ and below are “speculative grade.”
Russell 1000 Index
Measures the performance of the large-cap segment of the U.S. equity universe. It represents approximately 92% of the U.S. market, is a subset of the Russell 3000 Index, and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership.
Russell 2000 Index
Measures the performance of the small-cap segment of U.S. stocks and is a subset of the Russell 3000 Index, which encompasses the 3,000 largest U.S.-traded stocks.
Russell 3000 Index
Measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. stock market.
Russell Midcap Index
Measures the performance of the mid-cap segment of U.S. stock and is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership.
S&P 500 Index
U.S. stock market index based on 500 large companies’ market capitalization (total value of the outstanding shares); widely regarded as the single-best gauge of large-cap U.S. stocks.
S&P Municipal Bond Index
A broad, market value-weighted index that seeks to measure the performance of the U.S. municipal bond market.
WTI, or West Texas Intermediate
A classification of sweet, light (low-density) crude oil from Texas, used as a major worldwide benchmark for oil prices.