An Executive Summary from the Experts.
by Paul Stancs
Global stocks gained steadily in Q2, bolstered by economic data affirming the economic expansion remains on track despite Q1 weather-related weakness. The MSCI World Index rose 4.9% during the quarter and is up 6.2% for the year’s first half, already exceeding many too-cautious forecasters’ full-year expectations. Each new market high is met with disbelief and fears of heights, in our view, a sign investors have yet to embrace optimism, leaving plenty of room for sentiment improvement ahead. Improving sentiment against a better economic and political backdrop than most appreciate should continue pushing stocks higher in the second half, resulting in a back-end-loaded, up-a-lot year.
2014 is a U.S. midterm election year, which historically sees the strongest push in the back of the year. Midterm elections usually result in gridlock. Since 1932, only twice—in FDR’s and George W. Bush’s first terms—has the President’s party gained seats in both houses during a midterm contest. All other times, the President has lost relative power, reducing the risk of sweeping legislation interfering with property rights or distribution of wealth and income. Less political risk is a big positive for markets. However, investors are slow to realize this. Most folks get caught up in the campaign’s rhetoric and polarization, increasing fears that loud campaign pledges might actually come to fruition. After the election, however, the noise dies down, Congress continues doing next to nothing, and investors eventually realize most promises can’t pass. This is a powerful force for markets in midterm years’ second halves, particularly fourth quarters, which have been positive 86.4% of the time since 1925—significantly higher than stocks’ historical 68% frequency of positive quarterly returns. This effect extends over the following quarters—the first and second quarters of post-midterm years are also positive 86.4% of the time (a bizarre coincidence).
As folks look out over the next year, few fathom how strong it can be. Many investors remain wary of this bull market, continually checking for signs of a top.
While there is always a chance some unseen risk could materialize and knock the bull off course, we don’t see anything material enough to derail the many positives supporting stocks. Investors’ lingering skepticism combined with the underappreciated midterm effect and positive economic fundamentals tells us this is not the time to brace for a peak or wait for a pullback to put cash to work. Underestimating markets can carry significant opportunity cost.
You won’t see this perspective most anywhere else. As stocks clocked new highs while tensions flared in Iraq, eurozone growth slowed and new data revealed the U.S. economy contracted at a -2.9% seasonally adjusted annual rate in Q1, headlines warned of stocks’ apparent complacency, saying returns were too detached from reality. Yet stocks have a long, long history of shrugging off regional conflicts and bumpy economic data. Many claimed stocks’ resiliency this time was a result of Fed policy masking their underlying vulnerability, but this ignores decades of market history. It’s normal for stocks to rise when the world looks weak—geopolitical conflict and patches of sluggish (and occasionally negative) growth are often part of the proverbial wall of worry bull markets love to climb. While there are always risks, the time to worry most, in our view, is when headlines stop highlighting negatives and start ignoring them.
Today, headlines continue ignoring the positive. Even with the U.S.’s GDP contraction, S&P 500 corporate earnings rose 2.1% y/y in Q1—beating expectations for a small decline—and revenues rose 2.7%, illustrating the private sector’s continued strength.
This, not GDP is what you own when you own a stock. Nor was economic weakness universal. The global economy grew 3% y/y in Q1 as Emerging Markets surged and the UK led the developed world. Publicly traded firms appear poised to continue doing well looking forward, with most U.S. indicators showing growth resuming in Q2 as the impact of severe winter weather faded and loan growth continued its post-taper rebound. The Conference Board’s Leading Economic Index—one of the most reliable predictors of future economic trends—continued rising, fueled by the relatively steeper yield curve and credit conditions.
Risks exist—they always do—but there are no indications of sweeping monetary policy errors, a surge in trade protectionism, a deeply negative regulatory change or other similar barriers to more bull market. In our view, there is simply too much driving this bull forward for it to melt down—this is the time for a melt up.
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