Within small-cap, as measured by the Russell 2000 (INDEXRUSSELL:RUT) Index, non-earners, low return on equity (ROE), and non-dividend payers all outperformed in the first quarter. The good news was that late March saw signs of a re-emergence and shift back to the kind of quality names that we like.
Until the last day of the quarter, more than half of the names within the S&P 500 Index were down at least 5% from their 2014 highs while 20% were down at least 10%. This was a minor pause, not a major buying opportunity.
For sure, the market had been acting tired, with rather narrow gains. Through March 28, 2014, roughly 171% of the point gain in the S&P 500 (INDEXSP:.INX) came from the top point contributors, compared to only about 20% in 2013. The market is no longer broad but much more selective, which should be good for active managers.
On March 19, 2014, Janet Yellen, the new Chair of the Board of Governors of the Federal Reserve System, said, “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
It will be appropriate to maintain the current range of the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s two percent long-run goal and provided that longer-term inflation expectations remain well anchored.”
This quote allows for much wiggle room, especially in terms of time. In the same press conference, Yellen mentioned that interest rates could rise “in six months or so” following the end of quantitative easing. Was it intentional to release this negative assessment now to get it out of the way?
Yellen significantly reduced uncertainties (intentionally or not) when she mentioned this “six-months or so” time frame. Investors have now passed three consecutive psychological hurdles: Fed tapering, the end of QE3 (the third round of quantitative easing), and the time frame of rate hikes. This good news may lift equities even higher.
Clearly, the Federal Reserve meeting on March 19 had an effect on the market. Even the possibility of the Fed raising rates fostered a move to more quality-like attributes in stocks. This could be seen quite dramatically in the Russell 2000 (INDEXRUSSELL:RUT). Indeed for the first time in a long while underperformance occurred among the smallest market caps, non-earners, lowest ROE, highest beta, lowest share price, high growth expectations names, as well as non-dividend payers. It was about time!
Our outlook remains positive. The U.S. is an oasis in a global sea of problems, essentially independent of other nations. In addition, we have a growing population, a more laissez-faire economic system, rule of law, plentiful inexpensive energy—indeed, an energy renaissance—a manufacturing renaissance, and within a few years, we believe, balanced budgets—both trade and fiscal.
A couple of years back I used the phrase “the best house in the worst neighborhood” to describe the U.S. compared to other investment alternatives. I now believe it is the best house in the best neighborhood. Steven Rattner, the former head of Lazard Frères and the head of the U.S. government’s task force charged with bailing out the U.S. auto industry, seems to agree.
In an opinion piece in The New York Times on March 23, he wrote, “Most of the continent [Europe] just doesn’t feel as if it’s on the economic move. What ails its economies is a lack of what keeps the United States—for all of our problems—so high on the world’s leader board: flexible labor markets, the culture of innovation, immigration, and a relatively light regulatory touch.” Rattner went on to state, “German businessmen gaze wistfully at the United States with its free-flowing and cheap natural gas.”
The U.S. remains the bright spot in the global economy. Foreign direct investment in the U.S. has rebounded, supported by our manufacturing and energy renaissances, restrained manufacturing unit labor costs, relatively inexpensive energy costs, ease of doing business, and strong domestic demand. If you sell in the U.S., you are increasingly likely to produce or manufacture here also.
I believe there is little likelihood of interest rates rising soon. However, that does not exclude the possibility. Dismantling the monetary policies implemented since 2008 will clearly take exceptional skill.
While taper talk started in May 2013, rate-hike talk started in February 2014. Remember that the S&P 500 rose about 10% from May 2013 through the end of February 2014.
The market is no longer broad but much more selective, which should be good for active managers.
Talk is often worse than reality. No doubt rate-hike talk will continue. We frankly dismiss much of the rate-hike worries because the economy shows no signs of either overheating or inflation.
The falling bond yields, particularly in Europe, but to some degree here too, have decidedly deflationary overtones. Could the real worry about the winding down of stimulus be recessionary and deflationary? Is the market saying that we should not worry about rising interest rates? Related to this, who among us would have forecast that REITs (real estate investment trusts) and Utilities would be among the best performing sectors in the first quarter of 2014?
One byproduct of the inexpensive financing provided by the rescues of 2008-2010 is that it prolonged the life of marginal firms, adding to the physical volume of production and therefore to the weight on prices.
Debt is deflationary to the degree that it promotes production. Despite deleveraging, central banks still worry about declining prices as they boost the real burden of indebtedness.
Recently real GDP was revised up to 2.6% year over year for 2013’s fourth quarter, with an even lower benefit from inventory building. Therefore, this year’s first-quarter real GDP has an even easier comparison to last year’s 1.2%. The Fed reported that as of the end of 2013, U.S. household net worth was a record $80.6 trillion, which was some $11.8 trillion above the 2007 peak reached in the second quarter of that year.
Inflation—with the exception of food, particularly hogs, cattle, and coffee—remains restrained. We will continue to monitor the validity of the “one-off” thesis, which holds that weather and disease have caused some food items prices to spike.
Economic activity slowed during the winter months due to adverse weather conditions, though otherwise it appears that the U.S. economy continues to improve without causing inflation.
We are still of the belief that stronger top-line growth will have a magnified bottom-line impact via much higher-than-expected incremental margins due to lower break-even points.
Our twin budget and trade deficits are both improving. I believe it is likely that President Obama will leave office with a slight budget, as well as a trade, surplus if the economy stays on its current course. The resulting stronger dollar should put further downward pressure on commodity prices.
Any inflation scare, which could result from the temporary boost in the prices of food staples caused by recent droughts and cold weather, will be self-correcting.
The list of countries that could potentially cause problems for the rest of the world are all low in terms of global GDP (the percentage of global GDP