8 Feb 2013

Macro Strategy Update

Do Not Fear the Correction

2013 started with a bang. The Dow Jones Industrial Average is up 6.2% in January, the best start since 1989. Money flows into equity mutual funds for January are in record territory as investors begin to pile into markets1. Economic news have generally been better than expected while the current earnings season is proving the bears wrong. Markets are now in overbought territory and are susceptible to a pull back on any disappointing or negative news. A correction would be healthy for the bull market and it should be seen as a buying opportunity.

The economic news has generally been positive, supportive of the idea that global growth is accelerating. The latest round of PMI data points to further expansion, with the JPMorgan global manufacturing PMI at a ten-month high in January, up from 50.1 to 51.5. Contribution to growth was broad-based with US and China leading the pack. Europe and Japan are the exception, although they are now contracting at a smaller pace. The Eurozone manufacturing PMI rose from 46.1 to 47.9, while Japan's increased to 47.7 from 45.0. Services also expanded, albeit at a slower pace (54.8 to 53.6). Again the expansion was seen in various countries with the exception of Europe, which continued to contract at a slower pace.

The US economy remains on the growth track despite a fourth quarter GDP contraction. While a decline in government spending dragged down growth, the private sector's growth remained on track. Housing starts (Figure 1) and retail sales (Figure 2) continue their upward trajectory while durable goods orders (Figure 3) recovered strongly after a third quarter weakness. While such positive data is good, it is even better that upward revisions to various data points are happening. New home sales have seen positive revisions to the October (+3,000)and November (+22,000) numbers. Ditto for retail sales, with November's numbers revised up by 0.1%. Significantly, the 2012 payroll numbers were revised up by 335,000, that is 18% of the 1,835,000 jobs created that was initially reported. It is quite clear that statisticians are under-estimating the strength of the economy.

Figure 1: Housing starts

Figure 2: Retail sales

Figure 3: Durable goods orders

Perhaps it is not surprising that economic sensitive stocks have done well in the past six months. Stocks from the industrial sector (Figure 4) to the consumer sector (Figure 5) have outperformed the market. The continued strength in these cyclical sectors would likely indicate better economic data in the months ahead.

Image courtesy of Stockcharts.com

Figure 4: Industrials outperforming

Image courtesy of Stockcharts.com

Figure 5: Consumer discretionary outperforming

It is thus not surprising that investors entered the market with much enthusiam. Equity fund flows for January reached US$20.7 billion, a level not seen since April 2000 according to fund tracker Lipper. Markets have also reached levels that are overbought technically (Figure 6) which makes them vulnerable to correction.

Image courtesy of Stockcharts.com

Figure 6: Global equities are overbought

Corrections are healthy for bull markets as they allow fundamentals to catch up with markets. Since the June 2012 bottom, global equities have risen 23%. After avoiding the recession scenario, investors need to be assured that growth is returning. So far, the fourth quarter reporting season is proving to be good. About 73% of the 264 companies from the S&P500 that have released results this earnings season have exceeded analysts' forecast, and 66% have beaten sales estimates, according to data compiled by Bloomberg. This should give the bulls some comfort in that the disappointment with third quarter results back in October is temporal.

Despite the positive economic and earnings news flow, it is not difficult to see investors take profit on the current rally. Political risk, especially from Europe, continues to provide sufficient fodder to take risk off the table. Italian general elections are due at the end of the month. Investors will begin to fret when polls show anti-euro parties leading. This happened recently when polls showed Silvio Berlusconi gaining on his rivals, and Italian yields rose to a three-week high. The Spanish corruption scandal, which is threatening to bring down the current government, is also another reason to worry about the eurozone.

Nonetheless, we remain comforted by the fact that European financials have had a good outperformance (Figure 7) until the most recent correction in European equities. The EU is also helping by allowing countries to ease up on austerity measures. The EU's budget chief Olli Rehn signaled that Spain could be given more time to meet its budget deficit targets as the economy continues to contract. This is helpful for leaders facing elections at a time when growth, not austerity, is badly needed. Hence, the risk of a macro shock emanting out of Europe remains low, thanks also to the ECB's pledge to do whatever it can to keep the euro intact.

Image courtesy of Stockcharts.com

Figure 7: European financials

Another potential worry for investors is the automatic budget cuts for the US government. If unresolved, a US$1.2 trillion worth of spending cuts would automatically occur over the next decade. Yet, it is likely that a piece meal approach will be adopted to address this issue. President Obama has called on Congress to pass a smaller short term package to reduce spending and increase taxes - more can kicking down the road. This is probably why markets are pretty sanguine about the possible negative effects from Washington.

Conclusion

After a good six months, the bull market should and needs to take a breather. A 23% rally sets up a market that is ready to pull back when doubts creep in or expectations are not met. Investors should not fear when this happens and should take the opportunity to buy the dips.

Portfolio Positions

Whilst we are expecting a correction in the markets, the strong data seems to suggest that this will be more of a shallow technical correction rather than one that is led by fundamental data. As such we are not likely to take profits as yet as we see more potential for markets ahead. However this correction would probably be a very good time for investors which are overweight bonds to get into equities, especially those who had missed the last few rebalancing opportunities.



References
1. January Fund Flows Show Exuberant Investors: Strategic Insight, TrimTabs. 5 February 2013. AdvisorOne.

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