Secular Bull Update: Be ready for a possible market pullback
In the midst of the debt-ceiling debacle that sent the S&P 500 plunging in August 2011, our investment call that a secular bull was likely underway was a lonely one. Now we have plenty of company. In fact, at a recent gathering with other members of the investment community, Federated’s equity outlook was more middle-of-the-roadish. It’s enough to make one nervous. This isn’t meant to be a self-congratulatory missive. The point is once sentiment begins to change, it tends to move rather rapidly, bringing everyone along.
That’s what seems to be happening this year—bears who were getting pounded shorting stocks on “Lehman II’’ fears have been forced to get in if for no other reason than they need to make up ground and fast. Never mind the economic fundamentals laid out ad nauseam over the past few years as we made our bullish case—housing’s accelerating recovery, improving consumer balance sheets, a strengthening labor market, an accommodative Fed, and a fading crisis mindset—continue to be at play, setting the stage for much stronger growth now that the economic tide appears to be turning in the euro zone, U.K., Japan and China.
That said, there are reasons to believe a mild shakeout may be on the way in coming weeks. A lot of overhanging issues heading out of Washington’s doors and into the public eye are certain to raise uncertainty, and the market dislikes uncertainty. Watch for the “bears in bull clothing,” which is what I call the long-term bears pulled into this market due to the strong tape, to get washed out in the resulting volatility. This will set the stage for the next move up for us secular bulls, which is why we’ve been recommending investors to keep some powder dry. Here’s how we see the next few weeks playing out:
- Sun sets on Summers The thinking had been that, with a vote on Syria stalled, President Obama would likely use this window to try to push longtime confidante Larry Summers through as Ben Bernanke’s successor as Fed chairman. But in a surprise weekend announcement, Summers—viewed as a bit of a wild card and modestly hawkish—took his name out of consideration, a move the markets this morning were cheering on expectations liked-minded Ben Bernanke protégé Janet Yellen is now first in line to become chair when Bernanke’s term ends in January. Another potential candidate is longtime Fed member Donald Kohn, who also is seen as favoring ultra-accommodation and low rates for a long time. In any case, this unexpected development takes some worry and near-term uncertainty out of the market, and increases the perception that the new Fed chair will follow whatever policy direction Bernanke’s Fed announces after this week’s FOMC meeting. This is bad news for the bears.
- The Syria saga As tragic as it all is, this is something of a sideshow for the market. The range of outcomes at this point seems, on one end, nothing more than continued diplomatic negotiations that go nowhere, and on the other end, a brief bombardment of unmanned missiles into the desert, followed by diplomatic negotiations that go nowhere. An accord struck over the weekend between the United States and Russia to dismantle Syrian President Bashar al-Assad’s chemical weapons stockpile may have kicked the can on this issue, but it’s not yet clear whether it will work. What happens with Syria could determine whether there’s much fight left in the dog between the White House and House Republicans. Gridlock would be OK, but the market would prefer to avoid more fiscal showdowns.
- Fiscal fights Speaking of fiscal showdowns, we’re going to get some version of one whether we want it or not. Discussions already are starting to heat up over a continuing resolution/debt-ceiling deal that likely will carry over through October, with funding for the implementation of Obamacare playing center stage. With Summers out and a Syrian accord in hand, this rises to the top of potential short-term negatives for the market. We still think it will be resolved, but the process could be messy and market negative. Even if a deal is reached without a government shutdown, an outcome House Republican leaders would like to avoid given what happened in the Clinton-Gingrich face-off 20 years ago, we think the Tea Party element of the Republican House will at least put up a very big fuss. And now that the president does not have to burn political capital on Syria or Summers, he himself may be less willing to compromise with the Republican House. More uncertainty for the markets to navigate through.
This week’s Fed policymaker meeting isn’t included in this mix, if for no other reason than the market already has heavily discounted a positive outcome. Bernanke has guided the market toward a “taper lite” of around $10 billion and most would be stunned if he doesn’t do this at what essentially is his last run at the helm. The market also expects dovish language both on how the 6.5% unemployment target is a little fuzzy due to the rise of workforce departures—our fixed-income brethren think the threshold for maintaining the funds rate at effectively 0% may be lowered to 6%—and on how the 2.5% inflation target is not really a cap but is inside a range that could for some time be higher. All this would be taken as market supportive.
Stronger growth good for stocks
Looking ahead, we expect GDP growth to surprise to the upside in 2014 (3.2%), driven by release of pent-up investment demand for capital equipment, technology, housing, autos, other consumer durables as the world economy heals from the crisis days; a robust energy build-out; improved government fiscal balances (this year’s deficit will be the lowest in five years); and a pick-up in net exports as foreign economies stabilize. On the back of this, S&P earnings could accelerate to $120 in 2014, the market multiple likely will move higher and the S&P may close near 2000.
As for positioning, we continue to prefer cyclical sectors exposed to the economic acceleration over defensive sectors exposed to interest rates. In our model portfolios, we are recommending near-maximum equity overweight versus bonds, and would shift to a maximum equity overweight should we get the near-term pullback we expect. Among specific sectors, we like consumer discretionary, technology, financials and industrials. These are areas where we see the most earnings growth next year, which the market will key on. Within pure stock portfolios, we are underweight staples, telecom, and utilities, all of which have more exposure to the ongoing bond selloff which we expect as we envision the yield on 10-year Treasuries moving to 4% or higher by the year-end 2014 as growth picks up. However, within the income world, we continue to like spread product like high-yield bonds and the dividend-producing stock sectors noted above; although they will likely underperform more aggressive equity portfolios in the next up-leg, they seem certain to do better than government bonds as Treasury yields grind higher.