Can the Sweet Spot for Stocks Continue?

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1 leadership series market perspectives February 2013 Can the Sweet Spot for Stocks Continue? The U.S. stock market has been on a tear since Congress narrowly avoided the tax part of the fiscal cliff at the turn of the year. The rally has been impressive through mid-february, with the Dow up about 1,500 points since last November within a few hundred points of its all-time high of 14,246 set in October The S&P 500 Index is about 50 points shy of its all-time high of 1,576. Other indices, such as the small-cap Russell 2000 Index, have reached new alltime highs. Some analysts (including me) wonder whether the 13-year-old secular bear market is finally ending. 1 In my opinion, the rally has been robust because four important factors have converged to create a sweet spot for stocks: Economic momentum has improved, monetary stimulus was stepped up yet again, the tape (the market s technical condition) has been very strong, and last but not least, investor sentiment has turned around in a big way, with money now pouring into U.S. equity funds. Can the U.S. stock market stay in its sweet spot? Let s review these factors one by one. Factor 1: Economic momentum has improved There is no question that the U.S. and the global economy have improved in recent months. While U.S. GDP actually shrank slightly in the fourth quarter ( 0.1%), several other economic indicators have been pointing in the opposite direction. For the U.S. and indeed, most of the world the Purchasing Managers Index (PMI) has picked up steam recently. This survey of purchasing managers is an important gauge for the U.S. economy. A level above 50 indicates that things are getting better, and vice versa. The U.S. manufacturing PMI has risen from a low of 50.6 last September to a robust 56.8 in January, and the less volatile services PMI has remained fairly steady in the mid-50s; both suggest that the country is in a mid-cycle economic expansion. Jurrien Timmer Portfolio Manager KEY TAKEAWAYS Recent trends in economic momentum, monetary stimulus, technical conditions, and investor sentiment have converged to create a sweet spot for U.S. stocks. The equity market could continue to gain strength, but there are risks on the horizon, including China s overheating credit boom, rising gasoline prices, technical divergences, and spread product liquidity. Investors may want to own enough stocks to participate in a rally, while also holding enough bonds to provide diversification. Elsewhere in the world, there has been improvement as well. For instance, China s manufacturing PMI has rallied from a low of 47.3 last March to 53.1 in January, and even the depressed eurozone has seen some gains, with its PMI rising from a low of 43.4 last July to a still contractionary but improved So things look OK around the world maybe not gangbusters, but not recessionary either, and better than a few months ago. Does this mean we have the all-clear in terms of the fundamentals? Perhaps, but I am worried about a few things on the horizon. First, some of the high-frequency economic indicators, such as the Citi Economic Surprise Index and the ISI Company Survey and Economic Diffusion Index, are starting to roll over a bit (see Exhibit 1, page 2). These economic indicators tend to follow a 10- to 11-month cycle, and the cycle suggests that the economy is about to lose some momentum.

2 EXHIBIT 1: Are economic indicators peaking? ECONOMIC DIFFUSION INDEX Strong seasonal pattern of peaks in economic momentum followed by stock market corrections Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 MSCI All-Country World Index ISI Global Economic Diffusion Index (13-Week Average) Past performance is no guarantee of future results. Weekly data since August Source: Fidelity Investments, Haver Analytics, ISI as of Feb. 13, A peak in these economic indicators in the weeks ahead would fit with the economy s tendency since 2010 to appear stronger in the early months of the year, only to weaken during the summer. Some economists believe this is due to excessive seasonal adjustment resulting from the global financial crisis in 2008 and early Whatever the cause, the pattern is unmistakable. In each of the past three years, the global stock market has put in a high during the spring April 2010, May 2011, April 2012 then proceeded to correct 10% or more over the summer (Exhibit 1). So we need to be on the lookout for a possible repeat. In the eurozone, the European Central Bank (ECB) has been successful in reducing tail risk in the periphery, but that doesn t mean that nothing can go wrong. In Italy, there will be an election soon; with Silvio Berlusconi rising in the polls, there is some question whether the mainstream political parties will be able to form a coalition. And in Spain, Prime Minister Mariano Rajoy has been implicated in a scandal, leading some to wonder if he has been weakened politically. Also, with Europe s economy stabilizing, the euro has gotten much stronger, rallying from a low of 1.20 last July to a high of 1.37 on February 1. This has sparked concerns about the fate of export growth, especially in Germany. And then there s China. By all accounts, China s economy is on a tear again and that s good for global growth. But a look under the hood raises some questions about its sustainability. China s rebound is once again being led by a surge in lending, but this time it is not the traditional bank lending channel that is providing the liquidity (see Exhibit 2, page 3). China s savers have been shunning bank deposits in favor of higher-yielding and more speculative wealth management products, or WMPs, which are created when lending institutions collect deposits and package them to provide project financing. This more speculative shadow lending not the traditional bank channel has been providing the liquidity surge behind China s recovery. What s wrong with this? Perhaps nothing, but it remains an open question how sound these WMPs really are. It s mostly an untested market. What happens if some of the WMPs default? Will the banks make good on them? Will the project developers be able to refinance? Also, the surge in activity has been so strong that it is possible the Chinese government will worry that the economy is once again overheating and that inflation will become a problem as in That could lead to a government crackdown on shadow bank lending similar to the crackdown on traditional lending a few years ago. 2

3 EXHIBIT 2: A surge in lending is driving an economic rebound in China, but it is stemming largely from more speculative products and may not be sustainable SOCIAL FINANCING IN CHINA -50 Chinese government clamps down on lending Annual Increase in Total Social Financing (Renminbi, Billions) Source: Haver Analytics as of Feb. 13, New liquidity surge in China So the way I see it, China is surging ahead for now, and that is good for growth. But ultimately, either the Chinese government will have to clamp down or some of these loans will go bad. Either way, China could once again turn from being a global tailwind to a headwind a few quarters from now. Then there is the inflation aspect, and this may be the greatest concern. Now that China is surging and the dollar is weakening, oil prices are on the move again. With Brent crude oil trading at $118 on February 15, I m worried that a repeat of 2011 may be in the cards here. That s when the stock market was strong and China was overheating. This caused a spike in inflationary expectations, which ultimately led to spikes in Treasury yields and oil prices. In May 2011, the 10-year Treasury yield surged to 3.77% and Brent crude reached $127, which with the price of gasoline closely tied to movements in Brent was enough to negatively affect U.S. consumers. The U.S. economy quickly went into a soft patch that ultimately resulted in a 20% correction in the S&P 500 during the summer of There were other factors, of course, including the eurozone debt crisis, the debt-ceiling debacle, and the end of the Federal Reserve s QE2. But spikes in rates and commodity inflation clearly had an adverse effect on consumer spending. I worry that the same could happen in the weeks or months ahead, especially now that gasoline prices have reached a level that, in the past, has put a ceiling over the U.S. stock market (see Exhibit 3, page 4). Factor 2: Monetary stimulus was stepped up yet again Do not underestimate the power of central banks to inflate asset prices. This is, after all, the intended purpose of quantitative easing (QE). There is no doubt in my mind that while some of the market s recent momentum is the result of a better economy, as well as reduced fiscal cliff fears, the market has been on a sugar high delivered by the Fed s latest round of QE, and now also by the prospect of an important regime shift at the Bank of Japan (BoJ). This has raised the valuation of equity prices relative to the underlying economic fundamentals. That s fine as long as the momentum keeps going, but it creates the possibility that when the music finally stops, the market could be dangerously exposed to downside risk. This is true for equities, and it s also true for the credit markets. With highyield spreads over the 10-year Treasury recently falling below 500 basis points, there is little margin for error. A year ago, the ECB was the center of attention as its balance sheet ballooned higher after its two long-term refinancing operations (LTROs) injected large amounts of liquidity into the banking system. Now we are seeing its balance sheet shrink as banks start paying back those loans. But like a relay race, the baton has been passed from the ECB to the Fed, which is now buying $85 billion per month of Treasuries and mortgage-backed securities (MBS). And now the BoJ appears to be joining the party. With Shinzo Abe s election as Japan s prime minister, there has been increasing pressure on the BoJ to do more to end deflation and to devalue the yen. By committing to a 2% inflation target, the BoJ appears to agree, which suggests that we may soon see much more aggressive asset purchases by the central bank. There is even talk of the BoJ buying foreign assets. We are living in a world in which some central bank somewhere is printing money at any given time. This has raised fears of a currency war and competitive devaluation the so-called race to the bottom. The thinking goes that if all central banks are actively trying to devalue their currencies, ultimately it becomes a selfdefeating spiral that will just create chaos in the financial system as well as inflation. So, while QE has helped lift the stock market for now, we have to be aware of the unintended consequences that too much QE could bring. Factor 3: The tape has been very strong The tape refers to the stock market s technical condition, including breadth i.e., the ratio of advancing to declining issues and momentum. Both have been very strong, and this has created an important pillar of support for stocks. And for the most part, the tape remains pretty strong. It seems as though the all-time highs of 1,550 in 2000 and 1,575 in 2007 are acting like a magnet for the S&P 500, and it wouldn t surprise me at all if those levels are tested or even exceeded in the coming weeks. Given the tendency for major tops and bottoms to be accompanied by technical diver- 3

4 EXHIBIT 3: Do rising gasoline prices threaten stocks? When gas prices have hit this range in the past, stocks have bottomed out GASOLINE PRICES When gas prices approach $4, stocks have peaked Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12 Feb-13 S&P 500 Index U.S. Retail Gasoline Price (Average, USD/Gallon) Past performance is no guarantee of future results. Weekly data since August Source: Fidelity Investments, ISI as of Feb. 13, gences for instance, when an index makes a higher high, but a momentum indicator makes a lower high and given that such divergences are mostly absent at this time, the tape is telling me that a top may not be imminent. However, there is one potentially meaningful divergence that bothers me, and that s coming from the high-yield bond market. Highyield spreads bottomed on January 25 and have widened about 35 basis points (0.35%), even though the S&P 500 has gained another 20 points since that day, making consistent new recovery highs in the process. While these changes are pretty small, they re worth keeping an eye on because the credit markets tend to lead equities both higher and lower. Therefore, if this small divergence turns into a large divergence, it could be a sign of trouble to come. Now it is entirely plausible that this divergence is the result of investors selling bonds and buying stocks, and if that is the case it could be considered a good thing for stocks. This brings me to the final reason equities have been rallying, and that is the dramatic shift in investor sentiment. Factor 4: Investor sentiment has turned around in a big way A lot of strategists are wondering whether the great rotation has started. This is the name given to the prospect that investors will finally start to rotate out of bonds into equities, which they have been shunning since the U.S. stock market peak in October 2007 (see Exhibit 4, page 5). If a major shift is under way, it could be big enough to propel stocks higher for many months. And if that happens, we could indeed be at the beginning of a new secular bull market for stocks. But a great rotation may not be as benign as it sounds. Why not? Many people may be assuming that investors are hiding out in low-yielding money market and Treasury bond funds and that a shift into equities is a good thing. But there is little evidence to suggest that the average investor is sitting in Treasuries, which have been the domain of central banks. The more likely places for average investors are the so-called spread products like high-yield bonds, emerging-market debt, and bank loans. That is where the money could come from if and when the great rotation gets under way. 4

5 EXHIBIT 4: Investors are finally going back into stocks, and this could be a boost to the markets. USD Billions Oct-07 Apr-08 Oct-08 FUND & ETF FLOWS Apr-09 U.S. Equities Oct-09 $ $86.4 ETF = Exchange-Traded Fund. Cumulative net flows since October Source: EPFR Global as of Feb. 13, What s wrong with that? Maybe nothing, but the question is whether these markets are liquid enough to handle the redemptions should they occur quickly. In fact, Fed board member Jeremy Stein just published a paper on this; according to Stein, if spreads widen too quickly and the credit markets become unglued, that could be a source of trouble for stocks, rather than a source of support. The key is for the rotation to occur gradually. So, is the great rotation under way? The jury is still out. So far, there s no clear evidence that capital is coming out of either bond Apr-10 Oct-10 All Bonds Where is the money coming from? Apr-11 Oct-11 Apr-12 Oct-12 funds or money market funds in order to flow into equity funds. Rather, perhaps what we are witnessing is the typical beginningof-year seasonal inflows. Once we get past this seasonal period in a few weeks, we should have a better sense of whether a great rotation is in progress. What s next? Taken together, what do these factors mean? In terms of the economy, we know that the momentum has been good but we may be nearing a seasonal peak. We also know that oil prices are rising, so we need to be aware of the potential for a repeat of 2011, when stocks peaked in the spring, then retreated as rising gasoline prices crimped consumer spending. As for monetary policy, the Fed has been very accommodative for some time, and we have reason to believe that Japan is now taking a page from the Fed s playbook and stepping up its monetary stimulus. That could create further tailwinds for stocks worldwide, but it could also lead to an inflation scare, a currency war, or both. The technicals remain pretty solid here, and that bodes well for stocks, but the divergence in high yield is something to keep an eye on, given the tendency for stock market tops to be accompanied by various technical and intermarket divergences. Finally, sentiment has turned from highly risk averse only a few months ago to quite ebullient today. If this turnaround is part of the so-called great rotation, then it could continue to support stocks for months to come. But with spread products as the likely source of funds rather than Treasuries, we have to be careful that this rotation if that s indeed what it is does not happen so quickly that it destabilizes the credit markets. All in all, I see a U.S. stock market that may well continue to gain strength in the coming weeks, but there are enough risks on the horizon to warrant maintaining a balanced portfolio. That means having enough equities to participate in a rally, while also having enough bonds to provide diversification. 5

6 Author Jurrien Timmer Portfolio Manager Jurrien Timmer is a portfolio manager for the Global Asset Allocation (GAA) division at Fidelity Investments. Mr. Timmer is a 15-year veteran of Fidelity. He specializes in global macro strategy and tactical asset allocation. His work as an investment strategist and portfolio manager includes macroeconomic, technical, and quantitative disciplines. Mr. Timmer s research is widely used by Fidelity portfolio managers and analysts. Endnotes 1 See Are We at the End of the Secular Bear Market for Stocks? Fidelity Leadership Series, January Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Past performance is no guarantee of future results. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. Diversification does not ensure a profit or guarantee against loss. Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market or economic developments, all of which are magnified in emerging markets. ETFs may trade at a discount to their NAV and are subject to the market fluctuations of their underlying investments. In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. High yield/non-investment grade bonds involve greater price volatility and risk of default than investment grade bonds. Indices are unmanaged. It is not possible to invest directly in an index. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC. Index definitions Dow Jones Industrial Average is an unmanaged index of common stocks composed of major industrial companies and assumes reinvestment of dividends. S&P 500 and S&P are registered service marks of The McGraw-Hill Companies, Inc., and are licensed for use by Fidelity Distributors Corporation and its affiliates. The S&P 500 Index is an unmanaged market capitalization weighted index of common stocks. Russell 2000 Index is an unmanaged market capitalization weighted index measuring the performance of the smallest 2,000 companies in the Russell 3000 Index. ISI Company Survey Average is a weekly survey of U.S. companies that measures whether business is getting stronger or weaker (0=weak, 100=strong). ISI Economic Diffusion index is the 13-week average of a weekly index that measures whether countries economies are getting stronger or weaker (above 50 = stronger, below 50 = weaker). MSCI All-Country World Index (MSCI AC World Index) is an unmanaged market capitalization-weighted index that is designed to represent the performance of developed and emerging stock markets throughout the world. Purchasing Managers Index (PMI) is a survey of purchasing managers in a certain economic sector. A PMI over 50 represents expansion of the sector compared with the previous month, while a reading under 50 represents a contraction, and a reading of 50 indicates no change. The Institute for Supply Management (ISM) reports U.S. PMIs; Markit compiles non-u.s. PMIs. Citigroup Economic Surprise Index is an objective and quantitative measure of economic news. It is the weighted historical standard deviations of data. Products and services provided through Fidelity Personal & Workplace Investing (PWI) to investors and plan sponsors by Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI Products and services provided through Fidelity Financial Advisor Solutions (FFAS) to investment professionals, plan sponsors, and institutional investors by Fidelity Investments Institutional Services Company, Inc., 500 Salem Street, Smithfield, RI FMR LLC. All rights reserved. 6