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Last month we indicated that we were somewhat nervous about the very short-term outlook for stocks. Our concerns were due to the fact that markets had turned down in the second quarter in each of the prior three years, earnings were slowing down and more likely to miss expectations in the quarter, and investor sentiment had simply gotten too bullish recently. On top of that, economic numbers had softened after a robust start to the year in the U.S. The data from Europe had deteriorated further and, despite the optimistic plans of Prime Minister Abe to reflate the economy, Japan was still mired in a deflationary downturn. The U.S. economy had gone through a ‘spring swoon’ in each of the past three years, as shown by the ISI Diffusion Index in the chart below. The economic data in the 2nd quarters of 2010-2012 all showed some slippage from the 1st quarter, which lead to a correction in stock prices until the economic data turned up again in the 2nd half of the year. While we don’t think we will see the same sort of ‘swoon’ this year, the data has clearly been ‘missing the mark’ in the U.S., Europe and China over the past month.
While the pessimists on the global economic outlook had control over stocks for most of the past two years, we were concerned that the optimists on stock prices had taken too much control in the past six months, and that they were about to lose some of those supporting data. The most important component of our short-term worry about the stock market though, was the fact that the outlook for corporate profits in the first quarter was not likely to give the stocks the upward jolt that it has been giving during the past few years as profits exceeded expectations and forward guidance indicated further growth ahead. The chart below shows how the corporate profits report could be more of a ‘headwind’ rather than the traditional ‘tailwind’ for stocks. The left panel shows that S&P500 earnings growth has clearly slowed down over the past few quarters from the double digit growth rates of 2010/2011. The right panel also shows negative ‘preannouncements’ running at a rate of 3.56:1, higher than the 2.3 average of the past 8 years.
Early reports are still showing earnings slightly ahead of expectations but revenues are coming up short of expectations, and guidance for the 2nd quarter has been relatively uninspiring. Putting all of this together we saw the market as somewhat extended in the short term, particularly the defensive parts of the market, such as health care, consumer staples and utilities, where valuations had moved to excessive levels. We reduced our stock positions to underweight in Balanced Funds and initiated short positions in the U.S. and German markets in our Hedge Fund. We reduced positions in the U.S. financials and technology stocks as well as consumer stocks in Canada. Since cyclical/resource stocks had lagged the market’s ‘up’ moves so dramatically, we didn’t see as much downside for those stocks and therefore only reduced slightly our weightings in those sectors.
While the markets did pull back in April, the larger declines were in the economically sensitive sectors of the market, with Canada once again falling more than the U.S. and other industrial markets. Foreign investors in Canada seem particularly risk-averse as they continued to sell the smaller resource names on worries about Chinese economic growth and the idea that the commodity boom of the last ten years has come to an end. The chart below shows the performance of the CDNX, the key index for the Canadian Venture Exchange, which is the home to the smaller technology and resource stocks that aren’t large enough to list on the TSX. This group has taken the bulk of the losses in Canada. Since peaking in the spring of 2011, the CDNX has fallen over 60%, giving back a substantial part of the gains from the lows in early 2009. The index is down over 20% in 2013 alone.
We don’t see how this divergence between cyclical stock groups (such as those in the CDNX) and the defensive stocks can continue. Investors appear to want to put money into stocks because There is no alternative right now (the so-called ‘Tina’ market) since interest rates are so low. But investors don’t seem to believe in the global economic recovery so they are reticent to invest in the ‘cyclical’ or ‘growth’ sectors of the market and are instead just looking for dividend yield or stable growth and paying much higher than historical levels for these sectors.