I read a number of analysts, but these comments from Liz Ann Sonders at Charles Schwab are very timely.
LIZ ANN SONDERS: Happy summer, everybody. Welcome to the July Market Snapshot. I’m Liz Ann Sonders and it’s a pleasure to have this opportunity to share with you Schwab’s insights on the economy, the markets and the key drivers behind them. We’re so grateful that you’re taking the time to tune in, and as always, if you have any questions about the contents of this video please ask any Schwab representative.
Well, we’re past the halfway point for the year, and both a lot and very little has transpired, so what do I mean by that? Well, for all the consternation about interest rates, oil prices, the dollar, Greece, China, etc., the stock market has essentially been running to stand still, which is also, by the way, is the name of one of my favorite U2 songs. And I want to talk a bit about that, but I’ll start with the macro situation, talk a bit about global monetary policy and economic divergences-that’s been a big theme of ours-do a checkup on the US economy with a focus on jobs, wages, and, in turn, the implications for Fed policy, and then I’ll tie the macro into a look back at this year’s first half, which from a stock market perspective had some pretty unique characteristics. And then I’ll tackle a question I’ve been getting a lot about, how investors are positioned and whether we’re in a speculative phase for stocks.
So let me start with a little levity here. I was having a conversation with one of my colleagues, the very, very talented Charlos Gary, who is our resident cartoonist, among other things, and was talking about conceptually Janet Yellin and the Fed taking away the punchbowl, but other central bankers, adding to the liquidity punchbowl. And he came up with, what I think is a brilliant cartoon. In fact, when I tweeted it out it went nearly viral, so we’ve had a lot of fun with this. But I think Charlos did a great job, and I think it really is a very powerful picture in terms of what we are seeing. Yes, the Fed is moving toward initial rate hikes, effectively pulling the punchbowl away, but we have plenty of liquidity being added by the likes of the European Central Bank, the Bank of Japan, The People’s Bank of China.
So let’s start on this topic of monetary policy, and oftentimes when pundits are discussing monetary policy, global central banks’ balance sheets, in a world with all of this rampant quantitative easing, or QE, they compare balance sheets in absolute terms. They talk about, you know, $4 trillion Fed balance sheet. What we need to do is look at QE globally in relative terms. So what I mean by that is now that the Federal Reserve stopped quantitative easing last fall, they tapered it, they’re no longer adding to their balance sheet, but the Bank of Japan is still doing it, and the European Bank, Central Bank is, as well. What you see here is, relative to bond issuance, which are what the central bankers are buying via QE, what the Fed did was actually quite small compared to what the Bank of Japan is doing, has done, continues to do, and what the ECB just started doing and will continue to do. So here the ECB, European Central Bank, takes the prize. If you look at it relative to the size of the economy, here Japan’s quantitative easing program through the Bank of Japan takes the prize for the largest quantitative easing program relative to the size of the economy. So we can think about it in balance sheet terms, but we can also talk about it in relative terms, and the point is, yes, the Fed is pulling the punchbowl away but there’s plenty of liquidity being added by other central banks.
Now, in a somewhat circular pattern, kind of a chicken or egg, diverging monetary policy is a function of diverging economic growth and prospects around the world, that’s why they’re stepping in, but monetary policy is also contributing to those economic divergences. So let’s do an apples-to-apples comparison, looking at a couple of key regions around the world in terms of what’s been happening in the economy most recently. So this is a very popular set of indexes called the Citi Group Economic Surprise Index, and Citi Group puts them out for many, many regions and countries, and you see four key important ones here – the United States, Japan, the Eurozone and China. Now, this is not a measurement of absolute economic growth; it’s not a GDP measure. It’s a measure of whether economic indicators, the regular economic indicators for each of these countries, or in the case of the Eurozone, a region, are coming in better or worse than expected. So, if the line is above the zero line and rising, it means economic data is coming in better than expected. If it’s below zero and falling, it means there’s a net amount of negative surprises and deterioration. And what you see here is, back at the end of last year those surprises were actually relatively tight for all four regions, kind of clustered around that zero area, and then we started to see a pretty significant widening out about in the March timeframe, and it’s continued to do that, with the ebbing and flowing of this economic data relative to expectations, varying from country to region. And what you see here is Japan sits on top right now, so having the best economic data relative to expectations, the US is actually on the lower end of the spectrum, but improving, and then China at the very bottom here, but you see a very wide divergence between what’s happening in these regions. And, again, some of it is driven by monetary policy and monetary policy is also reacting to it.
Now, one of the implications of these divergences has been bigger swings this year among asset classes, and that helps to reinforce a mantra that any regular viewer knows, we’ve always espoused at Schwab, which is that global and asset class diversification is an essential part of a disciplined investment plan. So here’s an interesting look at performance over the past year-and-a-half of so. So the blue bar for each of these asset classes… and let me just go through that… it’s the S&P 500, the US dollar, trade-weighted dollar index, CCI is Continuous Commodity Index, so it’s commodities, EAFE is developed international markets, EM is emerging markets, and then you have Europe and Japan. So the blue bar for each is the performance for that index last year, calendar year 2014. Then the maroon bar is this year’s first quarter performance for each of those asset classes, and then the yellow bar is second quarter performance for those asset classes. And what you see here is a lot of movement from 2014 to then the beginning of 2015, and then a lot of reversals even in the second quarter in 2015, and I think it really highlights the benefit of diversification. And one of our themes this year, by all of us that would be considered subject matter experts, is that this is probably going to be the first year in a while where investors who take a much more diversified approach, particularly a globally diversified approach, won’t lament that decision, won’t think ‘Why wouldn’t I just index to the S&P 500?’ And that has a lot to do with these divergences.
But as most of you know, I tend to focus on the US markets and economy, so let’s dive in a little bit deeper on the US economy, especially as it relates to implications for Fed policy.
Now, we don’t have, yet, the data for the second quarter in terms of gross domestic product. We have the data for the first quarter, and it was not a great quarter, slightly negative, even after the most recent revision. But what you’re seeing in the table here is this idea of a first-quarter weak period for GDP is nothing new. It was not only a factor this year, we’ve had it almost every year since the recession ended six years ago. In the last 10 years, same thing, last 20 years, same thing. You can see this pattern of extremely weak first-quarter data readings for GDP, and then you tend to get a pretty significant pickup. Well, the bureau that creates the GDP data, that puts it together, the Bureau of Economic Analysis, recently conceded that there must be something awry with the seasonal adjustment. And at the end of this month they are going to come out with bigger revisions to all of this data to try to reflect some of the changes in the seasonal adjustment, so I would expect the first quarter to pick up even more from that anemic pace. That said, regardless of the adjustment we’re likely to get, we know the beginning of this year was not a strong one from an economic perspective. But we have to be mindful that GDP, as headline-grabbing a number as it is, is a lagging economic indicator, but since the stock market is a leading indicator we need to consider other leading economic indicators. So there’s a very well-known index put out on a monthly basis by the Conference Board called the Leading Economic Index, or the LEI for short, and you see a chart here of the LEI back to 1975, and what you can see, also, is, as the name suggests, it leads, and those gray bars are recession. So you see these indicators tend to roll over and give you a heads-up, typically, that a recession is coming.
What I have here with the dotted lines and the arrows are what I call round trips-basically, where the leading economic index turns down, you go into a recession, you start to rebound coming out of the recession. At the point where you’ve taken out the prior high, where you finally get back to where you were before the recession, that’s what you want to now look at in terms of the years. And what you see here is on average it’s about six years from the point that leading indicators finally get back to their prior high before we’ve had the next recession. The point is, we are within a breath of the leading economic indicators taking out their 2007 high, and that suggests, if history is some guide, that we have a ways to go before we have the next recession. Recessions come when there’s excess built in the economy. Excess in terms of inflation and tighter monetary policy, and we’re clearly not there yet.
Now, one of the other leading indicators is initial unemployment claims, which have been a consistent bright spot for the US employment picture and economy, and, in fact, as I sit here taping, it was a day we got the jobs report for June. So we not only got the latest claims data but we got the bigger jobs report, which was lukewarm-that’s the best way I think to describe it. Payroll growth was 223,000, that was a little bit under expectations. The details were not great. You had a decline in the labor force participation rate, people dropping out, which is the not so great reason why the unemployment rate actually fell to 5.3%. That said, we don’t think the report moved the needle significantly for the Fed, and we do remain in the camp that September is the most likely point at which the Fed begins hiking rates. Of course, we still have two jobs reports between now and then, which will take on great importance as we wait for signals from the Fed, and I’m going to talk a little bit more about this. But let’s take a look at some of the data that the Fed looks at when trying to decide what to do with interest rates.
This is a double chart here. The first one is just a simple unemployment rate, and then I’ve got three historic dots noted there, which was the point, as you can see in the second chart, which is average hourly earnings, or wages, the point at which wages started to accelerate, and what you see with the latest reading is we are actually below, at 5.3% unemployment rate, we’re below the level historically where wages really started to kick in, and that has not happened yet. We are seeing very, very subdued wages, and I think this has given the Fed cover to not doing anything yet at this point, even with the unemployment rate having dropped as dramatically as it had, and that they’re waiting to see that uptick in wages.
Now, not withstanding this weaker report that we got today, again, as I’m taping this, there are other broader, and more leading indicators, of wages that point to an acceleration, and, obviously, this is good news for workers. It may not be great news from a Fed policy perspective, but certainly good for workers. So here are two examples of some other indications of wages. The first one is the NFIB, National Federation of Independent Business. It’s a small business index, it’s small business optimism index that has subcomponents, one of which is the plans to raise compensation in the next three months, as all these small businesses are surveyed. And you can see, other than a recent little bit of a downtick, we’re well up off the lows in terms of plans to raise compensation. And then there are two other, in many cases, arguably, better, measures of wages. One is called the Employment Cost Index-it’s a broader measure than just wages-and the other is the ECEC, which is the Employers Cost of Employee Compensation, and it incorporates a lot of other things besides just wages, like benefits, etc. And you see here both of these have accelerated to a greater degree than average hourly earnings, suggesting that, even though this most recent jobs report didn’t see any growth in average hourly earnings, some indicators are suggesting that it’s coming.
But jobs is not the only mandate that the Fed has to be mindful of. The other one is inflation, and the Fed’s preferred measure of inflation is the PCE, which stands for Personal Consumption Expenditures. Now, there’s very little inflation today, by that measure, by Consumer Price Index, and we don’t expect it to accelerate significantly. In fact, if the Fed’s only mandate were inflation, like other global central banks, we probably wouldn’t be talking about whether it’s September or even December for the initial hike. We’d probably be talking about it as a next-year phenomenon. But there’s a form of inflation we do need to consider, which is asset inflation, for which the Fed deserves some credit, or blame, I guess, depending on your perspective.
So here’s an interesting chart that looks at household financial assets as a percentage of disposable personal income. Now, household financial assets are just that, but the two biggest components are equities and homes. You can see two very key, very important peaks that we have seen in this measure over the last 10 years or so. The first one was in 2000, at the peak of the stock market bubble. The second one was in 2007, at the peak in the housing bubble. And then you can see we’ve taken out those prior highs. The table associated with this chart is an interesting one, because when the Fed announced quantitative easing, it talked about wanting to see this buildup in asset prices to add to household net worth and make the consumers wealthier from a net worth perspective, and they would go out and they would shop more, and it would filter into job growth. Unfortunately, not only has that not happened probably to the degree that the Fed would have liked, historically, it doesn’t have a tendency to happen. So you can see in the accompanying table here that when you get into these sometimes called financial asset bubbles, you tend to have lower economic growth. It doesn’t necessarily translate into higher economic growth, and this is a little bit of a pickle for the Fed, because they haven’t seen the benefits accrue to the economy to the same degree they’ve seen the benefits accrue to the stock market, which has been a benefit to certainly investors who are participants in the stock market, but certainly not everybody across the spectrum.
Now, let me conclude right now this section on the Fed by pointing out another divergence, which only recently has narrowed a bit, and that’s the difference between what the Fed expects interest rates will do over the next several years and what the market expects interest rates will do. So you see a number of different colored lines here. Starting at the top is what the Fed was expecting the path of Fed Funds rate to look like back in September of last year. Every other Fed meeting they announce a new set of forecasts. December they lowered them again, March they lowered them again, and June they lowered them again. But notice the other line, the bottommost line, which is the market’s expectations for where Fed policy is going-pretty close at the end of this year, but still widening out into 2017. So the market is a little bit less optimistic about the economy and, in turn, the path of interest rates, than the Fed is. Our view is that the next move to narrow this will probably, again, be the Fed coming down to get a little bit closer to the market.
Now, speaking of the market, let’s move on and talk about the stock market. I’m not sure if I’ve shown this chart before in Market Snapshots, but it’s just a simple dot chart. Each dot represents a bull market, based on the standard definition of the market by the S&P 500 going up 20% and you can see the current, which is that maroon dot, compared to the average and the median, and this is every bull market in the history of the S&P 500. So, without a doubt, this market, this bull market, which is six-plus years old, is longer and stronger now, in duration terms, in magnitude terms, than either the average or the median. We’re not quite in the stratosphere yet like we were in the 1990s bull market, but certainly at a more mature phase in the market. But this year has been a particular unique year for US stocks, not because of any major fireworks but perhaps because of the lack thereof. This has been one of the narrowest ranges. In fact, through June 30th, it was the narrowest range to date in the history of the S&P 500, where you really have not had much movement at all around the unchanged level. In fact, as of June 30th, the S&P was almost incompletely unchanged, with a maximum gain at any point in the year of only up 3-1/2, and a maximum loss of negative 3.2%, so that is a remarkably narrow range. So what this data looks at is the top 10 narrowest ranges to start the first half of the year, to get a sense of what typically happened in the second half of the year. Will it give us some guide for when you do finally break out of this range, historically, which direction do you break out of? And the good news, if history is going to be some kind of guide, is that in every other year where we had a similarly narrow range in the first half of the year, as you can see in that rest-of-the-year column, the breakout was somewhat decidedly to the upside. You actually had no rest-of-the-year negative performance. And whether you look at it in mean terms or median terms, the performance was quite a bit better than any other typical, you know, second half of the year. So, again, history doesn’t always repeat but this is a potential positive in terms of historical guide.
Now, unquestionably, one of the reasons for this running to stand still characteristic of the market this year is the waiting game investors are playing as it relates to Fed policy, which we touched on. But an important consideration for investors should be less about the start date of rate hikes, which we, again, still think it might be September, but more about what the path looks like from that point forward. The Fed can do a lot of different things. In the most recent cycle, which was in the mid 2000s, the last time we saw a few years of the Fed raising interest rates, it was what I would call a fast tightening cycle, defined as raising interest rates by, in the case of that last cycle, by 25 basis points, or a quarter-point, at every single meeting. The Fed went 17 Fed meetings in a row, raising interest rates each time.
The opposite of that would be a slow tightening cycle, where the Fed doesn’t necessarily move every meeting. They might move, they might pause for a meeting, then they move again, maybe they pause for two meetings, much more slow. Now, we haven’t had any slow cycles, really going back… you have to go back to the 1970s. But the implications for the stock market, at least based on history again, are quite a bit different, whether you’re in a fast cycle or a slow cycle. So the blue line represents all tightening cycles in the S&P 500’s history. That dark line right at the zero point means the day they raised interest rates, and then you look a year before and a year after, so what does the market typically look like going into the start of a tightening cycle. And then once they start tightening, look at the difference between if they’re tightening at a fast pace or they’re tightening at a slow pace. So the way to read the scale on the left-hand side is it’s based at 100. So I’ll give you the numbers; you can see them down below. Fast cycles historically have seen a drop in the S&P 500 in the year following the initial rate hike. On the other hand, for slow cycles, the market was actually up almost 11% in the year following the beginning of a fast cycle. The reason why I bring this up is Janet Yellin, the Chair of the Federal Reserve, and most of the members of the Federal Reserve are taking great pains to express this idea that they’re going to be slow this time, and that has hopefully more positive implications for the market once we get past this period of uncertainty.
But let’s shift away from the Fed now and talk about some of the market’s other fundamentals, starting with valuation. We have slightly evaluated valuations relative to history. I think that also helps to explain the narrow range the market has been in this year. Essentially, the market may be pausing for earnings to catch back up to prices. This is just a standard forward PE, and you can see we’re a little bit north of the median. That’s not danger territory, but, again, may help to explain why the market hasn’t moved very much as we wait for this reacceleration in earnings. The net, of course, of all of this is that there has been a lot to worry about this year, and I think what that highlights is this so-called wall of worry that they say markets like to climb. It’s one of my favorite phrases about the market, and I think that wall of worry is very much intact. So let’s talk about how investors have been positioning themselves, because I think that also bears out this notion of a wall of worry.
I’ve shown this chart many times before. It looks at what investors are doing with their money in terms of mutual funds and exchange traded funds. So the blue line represents bond funds, all bond funds, and then the maroon line represents domestic and international equity funds, and by funds, again, I mean both mutual funds and exchange traded funds, or ETFs, and then the yellow is just domestic equities, so US equities. And what you see, I think, is fairly remarkable. Since 2008, on a cumulative basis, no net new money has gone into the US equity market. Now, that may be easy to explain back in 2008 and early 2009, when we were still dealing with the financial crisis and the market was in a very, very ugly stage, ultimately trying to find its bottom in 2009, but what’s harder to square is how pessimistic investors have remained in this six-year bull market. It’s only in the last couple of years where there’s been a picked-up interest in equities, but it’s been driven on the international side, not on the US side. This tells me that we very much have a wall of worry. And so far, by the way, so far this year, year-to-date, we’re in negative territory again. There’s more money coming out of equity, and there’s still money going into bonds.
Now, one of the bricks in this so-called wall of worry has been leverage, and specifically margin debt. And I want to talk about that now, because I have been getting a ton of questions about margin debt, and many pundits, you’re probably reading, who believe that we are at or near our market peak, will often point to the record high level of margin debt as either a factor or the factor in their bearishness. So given that it’s generating a lot of attention and questions, let’s take a look.
So, yes, margin debt is at a record, but it’s important to remember that margin debt tends to be a coincident index. In fact, about 25% of the time, going back to the late 1950s, margin debt is been at a record. It tends to track what the stock market is doing. Now, the accompanying table here does show that when margin debt is at a record, the stock market tends to do a little bit worse than when margin debt is not at a record. So, yes, it does maybe show some… too much optimism, too much complacency, but even when margin debt is at a record, the returns historically for the stock market have been pretty positive. In fact, one month later, six months later, one year later, fairly consistently positive.
And another factor we need to look at when looking at margin debt, is not just in absolute terms… yes, in dollar terms it’s at a record, but in relative terms as well, and here’s the more interesting one. The first chart here is just a simple chart of the S&P 500 back to the late 1990s. The second chart is the growth in margin debt relative to the growth in stocks. You have to look at it in relative terms. The market has gone up a huge amount in the last six years, and although margin debt is at a record, as you can see in the second chart here, relative to the growth of stocks it’s only marginally in positive territory and nowhere near the kind of peaks that you saw either in 2007 or 2000.
Now, notwithstanding the perceived high enthusiasm that is often associated with record margin debt, a good way to judge whether we’re likely at or close to some sort of breaking point for the stock market, would be to look long-term at how exposed investors are to the stock market relative to history. Now, I showed you a couple of pages ago the fact that investors in funds, mutual funds, ETFs, have not been buyers of stocks. Now, this looks at what percentage of household financial assets are in stocks right now, and you see it’s actually a little bit above the long-term average, which may beg the question from some, ‘I don’t get it. If people haven’t been buying stocks, explain to me how stocks have gone up.’ Well, the stocks that are already owned, even if people haven’t been adding to them, are up a lot in value, so that’s where most of that appreciation has come. But I want to point out… and I’ve got these blue-shaded areas which indicate kind of long-term periods of rising equity ownership… here, also, we are nowhere near the kind of peak that we saw back in 2000, or the prior peak, which was at the end of the major secular bull market that preceded it, that ended in the 1960s. So all of this, again, is an indication that the wall of worry is very much intact.
Now, let me close by talking a little bit about caution. As most viewers know, I’ve been a bit more cautious this year about the path of the stock market, certainly more cautious than we’ve been over the past five or six years. Now, a lot of the reasons for that increased level of concern in the near-term, we discussed today, we talked about Fed policy, etc., that’s a big one. But I think it’s this choppier market that has made very little headway so far, is more likely just a pause within an ongoing, what we call secular bull market, long-term bull market. I think that’s more likely the case than some sign of impending doom. I talked about some of the reasons why we, based on history, are more likely to break out of this tight range on the upside than downside. Now, I don’t think we’re past the drama yet. I would expect a bit more drama as we deal with what’s going on in Europe, and we deal with the slowdown in growth and some of the bubble characteristics in China, of course we’re dealing with the initial rate hike, so expect some volatility, but do, again, think that it’s just a pause in an ongoing secular bull market.
So, as always, I thank you for tuning in to this Market Snapshot, spending some time with us today. As always, Schwab Investment professionals can provide you with copies of today’s presentation, which I always recommend you get that. Sometimes you pick up things in these charts that you didn’t pick up when I was quickly going through some of them. And you can find all of our additional market commentary under the Insights tab on Schwab.com. So, again, happy summer. Have a wonderful warm weather environment, and we will see you next time.
