May 2015 Recap

There’s an antiquated stock market adage to “sell in May and go away”. The advice is really the back-end of an old two-step trading idea sometimes dubbed the “Halloween Indicator”. The idea is that the market performs best from November through April (inclusively), and that it’s a good idea to get out of stocks in May and sit in cash through the summer and well into the fall. While studies have shown that this very simple trading maxim actually has some statistical merit, the question a lot of folks have is: when do you sell in May - at the beginning or at the end of the month? Well, in 2015, it would have depended on whose stock market you were invested in. It would have been wise to stay invested in the U.S. stock market through the entire month, but if you had been invested in other stock markets around the world, then getting out at the beginning of May would have probably been best. The U.S. market, as measured by the S&P 500, fared better in May than it did in April, but world stock markets advanced less or were negative, and emerging market stocks posted negative returns for the month. Most U.S. and global bond indexes lost ground as well.

The capital markets struggled somewhat in May because of how investors reacted to uneven global economic growth and the geo-political and systemic fears stemming from the ongoing troubles in the Middle East and to the seemingly never-ending saga that is Greece right now. In the U.S., there’s still some hangover from the Great Recession working its way out of the system. Fiscal drag, the hit to household net worth, tighter lending standards, and general uncertainty still remain headwinds that have made this recovery a very slow one in historical terms. More recently, first quarter weakness in U.S. economic growth has been blamed on several factors, like the sharp plunge in energy prices, bad weather, and the West Coast port strike. But the second quarter hasn’t been much of a bounce-back period so far, and there are really no first quarter excuses to point to. On Friday, May 29th, the U.S. Department of Commerce published its revised First Quarter GDP number. The revision came in at a minus 0.7% compared to an initial positive reading of 0.2%. Obviously, not a good number and not what investors and the Federal Open Markets Committee (FOMC, “the Fed”) members wanted to see. Retail sales figures haven’t been climbing as expected, and despite solid employment gains and lower gasoline prices, retail sales were flat for April, suggesting that consumers are continuing to save rather than spend. However, consumer confidence rose in May and consumers’ assessment of the present situation improved, both indicators that consumer spending may pick up soon. Housing is an area of the economy that may be improving, as U.S. housing starts and new home sales in April were impressive.

European growth has exceeded that of the U.S. recently, due in large part to the ECB’s trillion-euro bond-buying program that began in March. Accordingly, the region appears to finally be recovering from recession as evidenced by unexpectedly good economic data, and should provide more of a tailwind for world growth. The Eurozone's economy grew 0.4% in the first quarter, according to Eurostat, slightly below expectations, but the pace was still far better than what the U.S. witnessed in the quarter. Still, several European Union member states are about done with Greece and some other periphery countries that refuse to make needed growth-boosting structural reforms to become additive members to the European Union (EU).

Evidence of this frustration can be found in the United Kingdom, which plans on holding a referendum vote on whether to exit the EU sometime before the end of 2017. Other developed world economies are at different places in the expansion / contraction cycle. Japan’s monumental stimulus plans are yielding positive results, for now, as first quarter growth there was the fastest since last year’s first quarter. Japanese GDP grew at an annualized rate of 2.4%, much stronger than the 1.1% rate in last year’s fourth quarter, and recent positive retail sales data bolsters the case that consumer spending there is reviving. In contrast, China continues to experience a slowdown in growth, which will likely not change any time soon.

For U.S. stocks, it will be difficult for the "Goldilocks" (not too hot, not to cold) investment backdrop to persist for too much longer. For the past six years, investors enjoyed an economic backdrop strong enough to push most asset classes higher, but not so strong that inflation or tightening monetary policy emerged as threats. With uneven economic growth and emerging signs of wage inflation, the investing environment is becoming more difficult and selectivity will become more important. As first quarter earnings season winds down in the U.S., the news wasn’t particularly good. While the results were slightly better than analysts’ modest expectations at the start of earnings season, overall it was a weak earnings season due to a still not strong U.S. economy, U.S. dollar (USD) strength that weighed on exports, and, probably most importantly, the continued pain in the energy sector. In fact, the energy sector of the S&P 500 is reporting the largest year-over-year decrease in earnings due to low oil prices causing the sector’s weakness to weigh heavily on earnings for the market overall. That said, earnings are ultimately what drive stock prices and with the current forward P/E for the S&P 500 at 17.1, stocks are at least fully valued relative to historic norms. This means stock prices don’t have much room to run without a pickup in future earnings. Another concern for investors is the unusually low level of volatility in the markets. A gauge that measures investor expectations of stock volatility has declined to a level far below its historical average, probably portending that this condition is temporary and that more volatility is likely in the near future.

The world’s developed markets saw mixed results in May, and the ones that did the best were the ones that have recently implemented enhanced stimulus measures. Japan’s stock market advanced more than 5% in May and is up almost 20% YTD. China’s benchmark index has surged almost 45% so far this year, but stumbled in the last week of May. The rapid ascent and volatility of China’s stock markets have raised concerns they may be in bubble territory.

The Fed is carefully trying to gauge the strength of the U.S. economy before raising short-term interest rates, which it hasn’t done since 2006. Fed Chair Janet Yellen said recently that she expects the central bank will raise interest rates sometime before year-end, although she wasn’t specific. She said the economy appears to be on course to bounce back from a sluggish first quarter, and downplayed weak economic data seen in recent months. Still, Yellen and her companions at the Fed are obviously aware that economic data remains mixed. Yellen recently commented that three major economic headwinds - deleveraging, drag from fiscal policy, and a weak global economy - have diminished somewhat, but are still areas of concern, causing the Fed to proceed cautiously with respect to the pace of normalizing monetary policy. The central banks of other countries continue to borrow pages from the Fed’s playbook. The European Central Bank (ECB) recently said the bank would accelerate its bond-purchasing stimulus program in anticipation of an expected decline in market liquidity during the summer. Similarly, the People’s Bank of China (aka the “Fed” of China) has cut its benchmark 1-year lending rate 3 times since 11/21/14, most recently on 5/10/15. Before the three cuts, China’s lending rate was 6.0%. After the third cut, the lending rate now stands at 5.1%.

Obviously, we monitor all of the world’s capital market and economic developments closely and constantly, especially during this period of unprecedented and coordinated central bank policy and action. Barring some external shock, we expect that risk assets like stocks will continue to outperform fixed income and other lower risk asset classes. We expect the USD’s strength versus other currencies to persist in the near term as well.