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Strength in global stock markets so far in 2012 has been supported by the fact that the U.S. economy is recovering, as demonstrated by the series of better overall economic indicators since the summer of 2011. The key reason for this recovery is because the two most important industries to U.S. growth are moving back to normal levels; housing and autos. After falling from an annual construction run of close to 2 million new homes per year in the 2002-06 period, new housing starts fell to an annual rate of around 500,000 over the last three years as excessive inventory levels and reduced demand lead to a collapse in home prices. While prices haven’t begun rising, they have stabilized and housing starts have risen back to the 700,000 range. This is still well below the ‘normal’ rate of around 1.0-1.2 million annual starts (which is the number of ‘new household formations’ in the U.S. each year), but clearly the trend has improved. A similar situation exists in the auto industry, where normal ‘replacement demand’ would put annual auto production at around 13 million vehicles. This number dropped to under 10 million after the 2008 recession but has now climbed back up to the 11 million range. This recovery in two key industries is also showing up in the ISI Corporate Surveys, which have recently moved up to highest level in over four years and show expansion of better than 3% in coming quarters.
The better economic results have prompted Goldman Sachs to become more bullish on stock prices. They recently put out a new trading call saying that stocks will probably begin a “steady upward trajectory” over the next few years as any declines in economic growth are already reflected in share prices. Their overall view is that they think it’s time to say a ‘long good-bye’ to bonds, and embrace the ‘long good buy’ for equities. The prospects for returns in equities versus bonds “are as good as they have been in a generation,” according to Goldman. They also suggest that gains in bond yields also can support equities. Ten-year yields have climbed from a record low of 1.67% set Sept. 23, to a recent high of 2.37%. Equities offer an opportunity now, and emerging markets may still generate the strongest longer-term results as those economies continue to grow faster than the developed economies.
Our own internal Asset Mix Indicator has been positive on stocks since the lows back in 2008. The indicator got to its highest level since that time in October, 2011, when it rose back up to 7 before stocks rallied. The recent level of this same indicator has moderated back to 4, still well above the ‘0’ or neutral level, but below the bullish level of last October. While economic growth risks have moderated somewhat since last year due to the improvements in the U.S. economy, sentiment indicators have become a bit extended and stock valuations are not quite as attractive as they were at the lows. The table below shows the make-up of our current reading, which corresponds to an approximate overweight of 115-120% of our ‘benchmark’ or ‘neutral’ weighting for stocks within our Balanced Funds. This compares to a level of 125-130% of benchmark equity weights that we were at when the market hit its low last October and our Asset Mix Indicator was at 7.
Even though the Federal Reserve has repeated many times that it will hold its key interest rate at exceptionally low levels through 2014, improving economic data have many investors wondering if the key rate could nudge higher well before that date. Canadian interest rates, which are also exceptionally low, would probably move higher, too. Bond yields are already rising: The yield on the 10-year U.S. Treasury bond recently broke above 2.3 per cent for the first time since October. The chart below shows the yield for the U.S. 30-year government bond over the last 20 years. While we believe that we have definitely seen the lows in interest rates, we also don’t expect a significant rise in rates anytime soon. We have left our ‘Monetary Conditions’ indicator at a bullish level of +2.
