Parsing the Market See-Saw

The see-saw action in U.S. markets during Q1 reflects the push and pull of several macro factors both at home and abroad. Here’s a quick rundown.

U.S large cap stocks took a breather in the first quarter, returning less than one percent. U.S. small company stocks and developed market inter­na­tional stocks did much better however, rising 4.3 and 4.8 percent respect­ively. Real estate investment trusts rose 3.9 per­cent—a resonant echo to their explosive 28 percent return in 2014.

Commodity crunch continues

Commodity prices continue to struggle. After losing 8.2 percent in the first quarter, the Goldman Sachs Commodity Index is now down more than 48 percent from its April 2011 peak. While energy prices have fallen furthest (-55%) and have garnered the most headlines, other commo­d­ities have also suffered, including agricultural (-43%), indus­trial metals (-41%) and precious metals (-34%).  This sustained and systemic price weak­ness is exactly the kind of thing that terrifies central bankers. They are willing to do just about anything to prevent massive deflation, which explains the current popularity of unconventional monetary policy, including quantitative easing

US Treasuries—the high yield alternative

In March, the European Central Bank became the latest central bank to unleash a massive quantitative easing pro­gram. The results have been drama­tic.

Interest rates in the euro zone have collaps­ed. Accord­­ing to a report in the Financial Times, a quarter of all sovereign debt in Europe has a negative yield and two-thirds of investment grade debt yields less than 1 percent. Even junk bond yields are plum­met­ing with half of Europe’s BB-rated junk bonds yielding less than 2 percent.

On the other hand, interest rates in the U.S. are rela­tively high. The accompanying chart will give a sense of the difference between U.S. rates and other major sovereign bond issuers. Investors with a 5-year horizon can buy a German Bund yielding -0.15 percent, a Japanese JGB yielding 0.07 percent or a U.S. Treasury note yielding 1.33 percent. Given the choice, is it any wonder that money is literally pouring into dollar-denominated bonds?

Falling euro, booming bourses

Falling European interest rates have put the value of the euro under tremendous pressure. Since last April, the euro has declined 25% versus the dollar, including 8 percent in Q1. Given the ECB’s unequivocal com­mit­ment to completing its $1.3 trillion quantitative easing program, the euro’s decline will likely continue.

Low interest rates and weak foreign exchange can be a potent mix for stock prices and recent European experience is no exception. In local currency terms, European stocks have been on fire since the January announcement of the ECB’s quantitative easing program. Some of the edgier markets like Portugal and Italy, have led the way. However, Greece—the edgiest of all—has been left behind. It is becoming increasing­ly clear to everyone (except perhaps the Greeks), that the Eurozone may be better off without them.

The strong dollar drags on the economy

The story is very different for the dollar. Rela­tively high interest rates and an improving economy have caused the dollar to strengthen. That’s all well and good, but after a while a rising dollar can be tough on U.S. economic growth. Economists estimate that a 10 percent increase in the value of the dollar reduces GDP growth by 1 percent. If that relationship holds, the 23 percent increase in the dollar since last summer will knock over 2 percent off GDP growth over the next couple of years from what it otherwise would be.

For equity investors, the impact is magnified by the rising dollar’s effect on corporate earnings. As U.S. com­panies sell products overseas, they have to trans­late those sales back into dollars. As the dollar appre­ciates, the foreign exchange loss on this translation cuts into corporate profits. This is one reason why earnings per share on the S&P 500 dropped to $26.77 in Q4 of last year from $30.50 in the prior quarter. If the dollar conti­nues to appreciate, the pressure on profits should continue also.

Soft oil prices should help…in time

Part of this pressure will be relieved by low oil prices. Falling oil prices initially hurt corporate profits. In fact, analysts estimate that Q4 profits per share on the S&P 500 fell by about $1 because of the decline in oil prices.  In the coming months and years, companies should make up for this immediate hit many times over as they experience lower raw material, manufacturing, and transportation costs.

The bottom line

While we remain favorably disposed toward stocks, our outlook has grown more subdued. We are now in the seventh year of a powerful bull market in the United States. In the course of that bull market, U.S. equity valuations have gone from dirt cheap to slightly rich. With a price/earnings ratio on the S&P 500 of 16.9x estimated 2015 earnings, we should not expect future returns to be nearly as robust as we have seen in the recent past. Instead, we are looking to other markets as the drivers of return including Europe and possibly the emerging markets. As always, diversification is the key to benefit from these trends while protecting your capital.

Steven Merrell CFP®, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: smerrell@montereypw.com.