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Slip Sliding or Up and Away?
Toronto: April 07, 2014
By John Stephenson

This last quarter for investors was anything but dull.  The S&P 500 started the year with a 5.8% tumble only to rally by more than 7 percent to finish up a modest 1.3%.  Market sectors that were the darlings last year were tossed aside as media, biotech and Internet stocks were for sale for most of this past quarter.  A spate of disappointing economic reports with weaker-than-expected regional Fed surveys, employment reports and ISM data have left investors in a grumpy mood.  Adding to the malaise was a brutal winter that has hampered growth and reduced first quarter economic growth estimates for the U.S. to below two percent.

Markets have been turned on their head, with commodities besting most other asset classes as droughts, Putin worries and signs of resurgent economic growth trumped the naysayers.  Soaring natural gas and food prices have helped power the commodity rally while U.S. equity investors have fretted over the seemingly lofty 15.3 times price-to-earnings multiple on the S&P 500.  Much of this anxiety seems misplaced; as only a small subset of the S&P 500 has elevated valuations, suggesting that the overall market is not in bubble territory. 

Regional disparities were also surprising with India’s main stock market clocked in up 7.5% gain, while Australia was up (ASX 200 4.7%), but Shanghai slumped 5.9% and Europe’s FTSE 100 was down 1.6% over the quarter.  The U.S. greenback fell against the euro and yen, while the Chilean peso was down 4.4% and the Brazilian real was 4.1% higher over the quarter.

Despite the gloom, developed markets around the world are displaying superior momentum when compared to emerging economies.  This can be explained by the pro-growth measures that have been adopted in the West.  In Japan, America and the United Kingdom, central banks have embarked on quantitative easing (QE) stimulus programs and in the Eurozone, rate cuts have stimulated the economy. In contrast, policy in Brazil, China and other emerging economies has been geared towards containing inflation pressures at the expense of growth. 

Many investors have viewed the strong markets in the United States with suspicion, fearing that the gains in years past has made the market too expensive.  But simple comparisons of market multiples to long-term averages ignores the important role of inflation in asset prices.  My research has shown that periods of under three per cent core inflation have had an average market multiple of nearly 19 times—suggesting that there is considerable upside in the market yet to come.

The biggest correlation between stock performance and the broader economy is the direction of earnings, which remains positive.  The overall direction of U.S. earnings is driven by economic activity, which is clearly expanding, aided by Fed policy which has kept credit flowing to the economy and is likely to continue to remain accommodative until late 2015 and beyond.  Only a recession in the U.S. could impair the direction of earnings and tank the stock market, an outcome that looks highly unlikely.

In Europe, the European Central Bank (ECB) finally looks poised to spur growth.  The ECB has been concerned about persistent low inflation and the strength of the euro, which has made European businesses less competitive.  March’s 0.5% year-over-year inflation print has set off alarm bells at the ECB and there appears to be a strong likelihood of them initiating a quantitative easing program, which would combat deflation as well as targeting a lower trading range for the euro.

With central banks in developed markets priming the pump, it makes sense to hitch your wagon toward countries and regions that are actively embracing pro-growth policies as opposed to those regions that are trying to constrain economic activity.

A shift upward in bond yields in the coming months should provide a powerful springboard for equities, coupled with a stimulus-fueled recovery in the Eurozone could provide a powerful one-two catalyst for stock investors.  While these sectors have taken it on the chin this past quarter, I continue to favor Healthcare, Autos, Technology and Financials as the fundamentals remain supportive and higher prices look likely once investor sentiment re-focuses on Western growth.

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