The dog days of May.

Looking at capital markets halfway through May, we find things are more or less where they were when the month began. Total returns in the domestic stock markets are close to no change as are those in bond markets. A tinge of risk-off preference is on display in the results for small-cap, international developed, and emerging markets stocks, as well as high-yield bonds—all of which have slipped by a percentage point or more. Volatility as measured by the CBOE Volatility Index (Figure 1) has meandered to lower levels and appears stuck in a range. Our decisions over the past few months to reduce portfolio exposures to near-benchmark levels seem justified as the markets sort through the incoming data to decide where to head next. Trying to pick where that next break will come is what investors need to focus on, so let’s take a quick tour of the major issues that may offer clues on what gets us off the treadmill.

Figure 1
Volatility appears to be stuck in a range

U.S. economic data round-up

The U.S. economy has been posting some dismal-looking growth numbers, but may be singing a slightly more robust tune:

  • Retail sales surged 1.3% month over month in April following the disappointing winter 1Q
  • Consumer sentiment was up, as was small business optimism, and job openings surprised strongly to the upside
  • Sales were up 0.6% month over month, which was double the median expectation, excluding auto and gas station sales

The positive sales report is similar to previous monthly bounces following slow periods that we’ve seen over the course of the recovery, and supports our position that consumers are still in a place to drive growth in 2016. The Atlanta Fed’s GDPNow estimate of second-quarter GDP is presently showing an expectation of 2.8% growth, up considerably from the last quarter’s results. The retail sales report alone caused this estimate to pop from 2.2% to 2.8%. The growth numbers do not forecast a breakout but they are looking much more robust and point toward a continued positive environment for U.S. investments.

Earnings a mixed bag

Also on a slightly better note, we are heading toward the homestretch on earnings for 1Q and the picture has brightened a bit. According to Fundstrat Global Advisors, we have earnings results for 432 of the S&P 500 companies which show a small bit of improvement, looking at the combination of results reported plus projected earnings. The overall results for 1Q2016 from 4Q2015 will still likely be negative but the decline is expected to be down to around 5%, which is an improvement from the high-single-digit declines expected at the outset. By the same token, earnings excluding the energy sector are likely to be flat, a change from modestly negative results expected previously. Sector-level earnings are showing some interesting results as it is either feast or famine. Only three sectors—healthcare, consumer discretionary, and telecom—are expected to post gains but these are all expected to advance by double-digit amounts, averaging about 14%. The other sectors are expected to post negative results with energy down considerably. Despite the better results that have materialized, the earnings story remains a mixed bag. Furthermore, as shown in Figure 2 which plots the price-to-earnings ratio for the S&P 500 index based on earnings projections over the next 12 months, valuations are reaching the top end of the recent range. If earnings do not move higher, upside for stock prices is likely to be very limited.

Figure 2
Valuations are reaching the top end of the recent range

Our next stop involves Federal Reserve policy and inflation. Market expectations for Fed rate hikes in the near term remain exceptionally low. The Fed Funds Futures market is showing a 4% chance of a rate hike in June, and only a 53% chance of a single hike before the end of the year. Fed officials are pushing back against that small possibility. Boston Fed President Rosengren, a longtime reliable “dove,” (not inclined to raise rates) indicated in a speech last week that the market expectation was too low. New York Fed President Dudley indicated that two hikes this year “seems like a reasonable expectation” in an interview with The New York Times. Despite these efforts, the Fed’s message is seemingly not getting through to the market, leaving this relatively large differential in outlooks. How this gap is addressed and closed will say a lot about how markets behave. The market would prefer for rate increases to reflect stronger economic growth and better earnings but as we have already reviewed, this outcome is unlikely. Inflation is more likely to be the driver as it is propelled higher by tight labor markets, rising oil prices, and a weaker U.S. dollar (USD). While this may give the Fed the ammunition they are looking for, markets could easily pull back in response to a situation that shows the Fed falling behind the inflation curve while the economy plods along. The Fed has not proven itself to be the strongest of communicators. That leaves us in the position of having to treat this Fed–markets disconnect as a big question mark that will likely keep us close to our benchmark home base.

A final stop is to take a look at emerging markets (EM), a place where we remain significantly underweight. As a quick reminder, this asset class is one that we like over the longer term as we look for these economies to mature and transition more into modern, growth-oriented companies, but this is a transition that we feel is still somewhere down the road. However, the almost-uniformly ugly picture painted by this sector is beginning to have some brighter-looking prospects. Ned Davis Research has recently pushed for an EM overweight, believing that the global earnings downturn has nearly leveled off and should be poised to reverse course.

Other positive factors include a turnaround in many commodity prices, a reduction in the value of the USD, and some evidence that the penchant for socialist government may be losing ground as shown by the recent actions in Brazil, where its president faces an impeachment trial. However, EM still faces an uncertain future due to our Fed, which could disrupt some of these fledgling positives if it believes rate hikes must be initiated relatively quickly, a move that would likely push the USD somewhat higher and cause a partial replay of the EM difficulties seen late 2015 and early 2016. Like many of the other areas just discussed, we have a good idea of what we need to see before changing our investment outlook … but so far little evidence that we are getting closer.

Have comments or questions? Please share them with your Investment Advisor.

Market statistics

As of May 17, 2016

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Barclays Aggregate Bond Index
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.

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.

Quality ratings
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. 

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