May 6th was volatile. This was the day that:
S&P 500 intraday was down 2%, then down 8.6%, and at close down 3.2%;
Treasuries were in the midst of a flight to safety rally;
Eurozone bonds in Greece, Portugal, Spain, Ireland, and Italy continued
This market was long in the tooth and was waiting for a catalyst. Why?
Sell in May and go away...an old adage but a useful one. May is a pretty disappointing time for stocks. In the last 20 years, May was down or flat 83% of the time for both the S&P 500 Index and Russell 2000 Index. This year is likely to prove the same.
An Inauspicious April: Despite a strong earnings season, Treasuries (GT10 and GT30) outperformed the S&P 500 by 30bp to 200bp. EPS were 7% above consensus but revenues only 1.5% above. So the "beats" were good but mostly because the street underestimates the benefit from improved management of the "middle" line (i.e. expenses) and improved productivity (i.e. delivering the same output with fewer workers). Even so, for the market to return the same as Treasuries suggests the economy is not growing great guns and that some of the best news may be over.
Uncertainty: There's lots of it but here are the ones that top our list:
1. Greece: It's not a question of if Greece will default but how. Countries do not come back from this sort of brink (debt/GDP of 115%, deficit/GDP of 13.6%) without a major restructuring. It will come in the form of debt extension ("congratulations, your two-year bond is now a 20 year bond") or principal haircut ("...and you get 80c on your euro"). The EU will pretend they're managing the bailout but behind the scenes will be a shambles.
The euro is plummeting and there will be a flight to quality until there's some settlement. Pictures of rioters and Molotov cocktails are not good for confidence but are good for U.S. Treasuries.
2. Financial Reform: It's on again but in the hands of politicians, who markets tend not to like. The issues fall into one of these categories: derivatives, consumer regulation, size, "too big to fail," and proprietary trading. The
only thing that is good for banks in the short term is for nothing to happen, which is unlikely. Remember that financial companies tend to say "No.... and what was the question?" when it comes to reform. All investment
banks virulently opposed the Glass Steagall repeal in 1983 (the Financial Institutions Deregulation Act of 1983) because they didn't want commercial banks on their turf! Not the brightest bulbs so expect a lot of argument until
this is sorted out.
But think on this: If banks are too big to fail, and they clearly are because they brought the system to its knees, then that is the same as saying our economy depends on the nine, too-big banks (i.e. with balance sheets over 3% of GDP) which should give any Jeffersonian pause for thought.
3. Economy: The numbers are OK but that's all. We have good reports on personal income, manufacturing, and GDP growth. The worry is: How much will be sustained as incentives and government stimulus expire? Jobs are not really heading anywhere. The ADP employment report (which tracks private sector employment and so excludes all those pesky census workers) showed modest gains only. This is probably the most important statistic to look at in the next few months and could be a game changer. Nonfarm payrolls came in today at 290,000 and beat the consensus estimate of 190,000. However, two points: 1) the unemployment rate rose as the labor force grew, and 2) the numbers are prone to revision. Remember, we still need 200,000 new jobs every month for years to make any dent in unemployment.
There's a lot of unused capacity in the economy; inflation is not showing any signs of uptick (to those who see the TIPS rally as evidence, remember it's a very small part of outstanding government debt and so tends to distortion) and unemployment remains high. This is not the stuff of inflation. Commodities are not the harbingers of inflation they used to be because finished goods rely so little on raw commodity input prices. In fact the only reliable indicators are wage push and capacity utilization. And both presage flat prices.
Market Behavior: The reporting season is drawing to a close. In the S&P, 422 have reported, 76% with positive earnings surprises. Earnings growth was about 26% year-over-year, excluding financials. But the easier comps from 1Q 2009 are over. Expect earnings growth to moderate for the rest of the year.
What we have seen is a one-way drive to low quality stocks both in the small-, mid- and large-cap universes. For the fifth straight month, the smallest market cap stocks, non-earners, lowest ROE quintile and stocks priced under $5 had the best performance. This happens when operational and balance sheet leverage works, risk trades are on and momentum your friend. Some of the sectors that have done well, including autos (+18% YTD) and airlines (+25%) are notorious destroyers of shareholder capital and volatile trading stocks. None of this lasts for long and there could be quite a reckoning for poorer quality stocks in the next quarter or two.
Outlook: This is a time to stand aside. The train coming at us is "Fear of Contagion." That means contagion of who's next after Greece and who is exposed to Greece (answer... European banks where the 20 largest banks are down over 25% in the last month). So from that fear we get euro weakness ( down 16% YTD and down 7% in a month) the financial services sector off 11% in two weeks and a run to quality. Ten and thirty year Treasuries have run up 4.3% and 9.6% since April 1st. We stand by our December forecast that 10 Year Treasuries will trade in a range of 3.60% to 4.00% for the year.
So we see the balance of the year as:
1. Treasuries in the 3.6% to 4.0% range. Some upside break is possible but unlikely while the employment picture
2. U.S. equities to trade on fundamentals. . . with many corrections and buying opportunities.
3. Overseas should do well for the year but for now Euro bears have the upper hand. These markets hold much
of the key to world growth and when Greece is resolved, we should see good buying opportunities.
Christian W. Thwaites is president and chief executive officer of Sentinel Asset Management Inc. This commentary was originally published in Sentinel's Market Insights publication.