U.S. equities finished lower last week as the S&P 500 declined 2.6% and suffered the largest weekly pullback since June 2012. U.S. stocks are down approximately 3% both year-to-date and from all-time highs. In 2014, lack of direction in the market has been a focus, and the waning influence of macroeconomic news caused a notable shift late last week.
Dampened growth momentum in China weighed on global risk assets and helped to deepen the negative sentiment that already had engulfed emerging markets. The peso devaluation in Argentina seemed to put contagion concerns back in play, exacerbating the selloff.
Somewhat softer manufacturing and housing data appears to have put a dent in the U.S. growth momentum theme that was a big driver of the run-up in stocks in late 2013. Discussions continued about expectations for a pickup in capital expenditures. Washington, D.C., crept back into the headlines, and the debt ceiling is now expected to be a pressing near-term issue.
There is growing investor anxiety about the strength of global equity markets following their strong run in 2013, especially in light of a slightly lackluster economic backdrop. Many equity investors are questioning the efficacy of monetary policy, the level of profit margins and valuations, the threat of Fed tapering and geopolitical risks. Five years after a harrowing economic recession, equity investors still appear largely focused on risk.
WEEKLY TOP THEMES
Fourth-quarter earnings season announcements are showing stronger signs. Thus far, 68% of companies reporting 4Q 13 earnings beat consensus expectations. Approximately 25% of S&P 500 companies have reported earnings.
Severe weather across much of the U.S. will likely impact economic data in January. Once temperatures return to normal, a bounceback could unfold.
We expect the Federal Open Market Committee to cut its monthly asset purchases by another $10 billion next week. Despite concerns about emerging markets and a weak December payroll report, it is anticipated the Fed will reduce its purchases to $65 billion per month, and leave the interest rate forward guidance unchanged.
President Barack Obama will deliver the State of the Union address Tuesday. Income inequality is expected to be a major theme, though it is unlikely any proposed major policy initiatives will pass in Congress. Mr. Obama will probably also urge Congress to increase the minimum wage and pass extended unemployment insurance benefits. Due to a number of factors, not many areas outlined in the agenda will pass into law this year.
The correlation among stocks has been declining in 2014 and is now at the lowest level in more than a year. As correlations fall, stock selection often becomes more important.
THE BIG PICTURE
A correction in equities may be under way. A price correction would be natural after the substantial increase in prices over the last few months. Potential areas of concern include the squeeze in China's shadow banking system, increasing currency instability in several emerging-markets countries and a renewed spike in interbank borrowing rates in the eurozone. Nevertheless, none of these issues are likely to significantly unsettle the global economy.
Bear markets have almost always coincided with economic recessions.
Today, the developed world has barely recovered from the 2008 financial crisis, and it is not probable that another recession will emerge soon. If this conclusion is correct, the bull market should remain intact. Investors seem to be more upbeat about the world economy and prospects for stocks than they were 10 months ago, but signs of a bubble are not yet prevalent.
A forward P/E ratio of 16 for the S&P 500 is not viewed as extreme, compared with a 10-year U.S. Treasury yield of 2.75%. We believe the sweet spot for equities is when the underlying economy remains weak but recovering, and monetary policy is stimulative.
We have been in the sweet spot for some time, and it is likely to continue.
Profit growth is about to accelerate. The eurozone is coming out of a recession and the U.S. economy remains below its potential. Also, inflation rates in G7 countries are below central bank targets. Overbought conditions and periodic worries about the impact of Fed tapering, particularly in emerging markets, is causing near-term choppiness. While the current turmoil may not be over, current conditions do not suggest a sustained decline in equity prices.
Robert C. Doll is chief equity strategist and senior portfolio manager at Nuveen Asset Management