Young Americans: The Death of Equities May be Exaggerated

Tuesday, August 21st, 2012

August 20, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• PIMCO founder Bill Gross believes the “cult of equity is dying” … let me take the other side.
• Mutual-fund flows suggest that we may have lost a generation of investors.
• However, demographics suggest there may be another generation that could be the stock market’s savior.

Rumors of the death of equities may be greatly exaggerated. Bill Gross, founder of PIMCO, recently wrote that the “cult of equity is dying,” and of course it generated a furor of interest. In a separate Tweet, Mr. Gross noted that disillusion with stocks “might be a generational thing.” I have great respect for Bill and was very fortunate to share the stage with him at the opening of last year’s Schwab IMPACT conference. He was no more optimistic then than he is now and several media outlets that covered the conference called me the “optimistic ying to his pessimistic yang.”

Bill’s recent comments didn’t do much more than repeat the view he’s held for some time. I remember reading back in February 2009 an interview he did with Forbes Magazine in which he opined, “…things will never be the same. Risk taking has been destroyed and any animal spirits must come from Washington. Global growth rates—low, low, low—asset classes will be readjusted for that outlook. That is—stocks will be more of a subordinated income vehicle as opposed to a ‘stocks for the long run’ growth vehicle.”

Not just a lost decade … a lost “baker’s dozen”

Needless to say, the timing of those comments was not ideal as the stock market bottomed the following month and has since doubled. This missive is by no means an attempt to discredit Bill or his views, as there’s a lot of truth to what troubles him. Frankly, they’re the same truths that continue to plague the psyche of the majority of individual investors that are indeed shunning stocks as if the recent lost decade (or, more precisely, lost “baker’s dozen” given that the S&P 500 index is presently at levels equivalent to where it traded back in 1999) will be repeated.

I know that this opinion may elicit many of the same comments I’ve heard following other contrarian views I’ve expressed over the past three years—that I’m yet another “perma-bull” with blinders masking long-term structural problems that will forever plague stocks. First, I’m not a market timer, but I’m also not a perma-bull. Long-time clients may recall we were decidedly pessimistic about the outlook for both the economy and stock market leading into the 2007 top and didn’t turn optimistic until the spring of 2009.

I remain optimistic longer-term, albeit it with near-term concerns due to the obvious pressures still with us thanks to the ongoing eurozone crisis, the looming US fiscal cliff and related election uncertainty, and slowing global growth. But it’s the longer term that’s the focus of today’s report.

Being a contrarian

I’m never a contrarian just to be contrarian, but sometimes tacking against the winds of the market and investor psychology can be amply rewarded. Stock market sentiment has always been driven by what the market has done in the past, not by a fundamentally based consideration of what might lie ahead.

Short-term sentiment measures will always ebb and flow with market action, but most longer-term sentiment measures show a level of despair about stocks unmatched in the post-World War II era. One need look no further than mutual-fund flows: the chart below shows a $1.4 trillion spread between bond-fund inflows and stock-fund outflows—a spread unmatched in history.

An Unprecedented Show of Risk Aversion

Source: FactSet, Investment Company Institute, as of June 30, 2012.

A wave of shocks

The inflows to bond funds are easy to explain given strong returns (until recently). But they’re also characteristic of aging Baby Boomers’ risk aversion and reactions to a veritable wave of shocks to both the system and investors’ psyche, including, but not limited to:

• The lost decade (or as previously mentioned, the lost “baker’s dozen”)
• The dramatic decline in the stock market from 2007 to 2009
• Periods of unprecedented market volatility
• The 2010 “flash crash”
• The growing dominance of high-frequency trading and its effect on market behavior
• The 270-point average daily Dow swing in 2011′s August-November span related to Standard & Poor’s downgrade of US debt and the debt-ceiling debacle
• Facebook’s disastrous initial public offering and subsequent price performance
• JP Morgan’s huge trading loss earlier this year
• Another Ponzi scheme in the form of Peregrine Financial Group (and related attempted suicide by its founder), coming on the heels of the Bernie Madoff and Allen Stanford scandals
• The “LIBORgate” rate-setting scandal

The bottom line is that the demise of interest in stock investing by many individual investors is in very large part due to a total lack of trust in the transparency and fairness of the market. This is understandable.

I often get asked whether there’s any hope for the market longer-term if individual investors remain on the sidelines. History may be a guide. As noted by The Leuthold Group this spring, there were two stock market climbs the public missed. The first was the advance from 1974 to 1980, which lasted more than six years and amounted to a 120% gain for the S&P 500, and a multiple of that gain in small-cap stocks. However, US-focused mutual funds enjoyed net inflows in only 15 months during this run. The shallow bear market of 1976-1977 likely shook out many would-be buyers … and contrarians might note the high of that entire move coincided with the first sizable month of net inflows.

More recently, during the current cyclical bull market (since March 2009) there have been two sharp declines in both mid-2010 and mid-2011. They probably served the same purpose as the 1976-1977 decline—scaring off many retail investors just as they were finally preparing to tiptoe back in. It’s hard to fathom that a majority of individual investors could remain sidelined in the face of a continued strong rally in stocks, but the late 1970s showed that it can happen.

Back to demographics and the “Millennials”

In history, few forces have been as strong behind stock returns as demographic trends: movements in population, age, gender and employment status, among others. Much focus has been on Baby Boomers, especially as they begin to retire, and their effect on markets in the future. Yes, they’re now more risk-averse than ever, and this is not likely to change. But what about a key generation behind them?

Those born after 1980 are generally considered “Millennials,” but I prefer the description “Echo Boomers,” as they represent many of the children of Baby Boomers. Millennials are often characterized as having less financial savvy and weaker job prospects than their Boomer parents. The result is an impression of a generation equally as disenfranchised from the stock market as the Baby Boomers.

However, I think many may be underestimating the positive impact this generation may have on investing trends. I recently read an interesting report on the subject by Turner Investments in which it noted that the Millennials are “digital natives”—the first generation raised with technologies such as personal computers, the Internet and smartphones that prior generations had to adapt to later in life.

My two children (ages 12 and 16) can’t fathom that I had to rely on libraries, books, encyclopedias and a typewriter when I was a college student. But they’re part of a generation that’s become completely reliant on “new” technologies. Eight of 10 of Millennials sleep with their cell phones in reach (count my kids in the 20% that don’t, though they would if we let them).

The Millennials are highly educated: About 40% of college-age Millennials are enrolled in higher education—the greatest percentage in US history. Yes, some of that’s a result of the rough economic ride they’ve been on over the past decade or so. They’ve had to suffer two economic/market crises since 2000, starting with the bursting of the technology bubble and followed by the bursting of the housing bubble and the attendant financial crisis. The dearth of jobs has hit the generation particularly hard. About a third of 18-29 year olds are unemployed, under-employed or simply out of the work force.

Don’t underestimate the Millennials

Turner offers seven reasons why the financial prospects of Millennials may be much better than is popularly supposed and why Millennials may “bring about a Great Bull Market of the 21^st Century”:

1. The Millennial generation is huge at more than 85 million—even larger than the Baby Boomers’ 81 million. It wasn’t until Boomers were in their 30s that they began to truly make their presence felt in the stock market. The great bull market of the last century was the result. My additional perspective: vehicles like 401(k)s make it easier and more “automatic” for this cohort to invest.
2. Millennials’ financial struggles thus far are actually fairly typical of early adult life: paying for education, finding a first job, relocating, buying a first house and learning the vocational ropes.
3. Macroeconomic headwinds facing Millennials—notably high unemployment and depressed housing—are likely to be temporary. My additional perspective: housing has likely already found its bottom and household formation has jumped significantly since its lows.
4. Baby Boomers once faced similar macroeconomic headwinds (during the late 1970s and early 1980s), but were still able to subsequently invest in stocks and drive the market to new highs during their peak earning years.
5. Despite all of their financial troubles, Millennials are savers and are already investing in stocks. Twenty-something investors have more stocks in their 401(k) accounts today than their counterparts did a decade ago, according to the Investment Company Institute. About 80% of 20-somethings had devoted at least 60% of their 401(k)s to stocks in 2010 (the latest year of data) versus 70% in 2000.
6. Millennials tend to be optimists and are more willing to take risks relative to their parents’ generation. About 29% of all entrepreneurs are Millennials, according to the Kaufman Foundation, suggesting an appetite for risk.
7. Millennials are putting emerging nations in a demographic sweet spot. The ratio of workers to the total populace in East Asia rose from 47% in 1975 to 64% in 2010. In Latin America the ratio rose from 44% to 56%, and in South Asia it rose from 45% to 55%. A sizable new class of investors is surfacing around the globe.

Food for thought.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Copyright © Charles Schwab and Company

Tags: Animal Spirits, Asset Classes, Bill Gross, Charles Schwab, Chief Investment Strategist, Disillusion, Forbes Magazine, Founder Bill, Furor, Global Growth, Impact Conference, Individual Investors, Liz Ann, Media Outlets, Missive, Mutual Fund Flows, Risk Taking, Senior Vice President, Tweet, Young Americans
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Housing: Good Vibrations (Sonders)

Thursday, August 2nd, 2012

July 30, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• Household formations are moving higher but housing completions aren’t keeping pace.
• Real mortgage rates plunge into negative territory.
• Key housing market index indicates continued sales (and pricing) recovery.

I’ve penned quite a few reports dedicated to housing over the past six years or so, the most recent being my “Rock Bottom” report in January of this year. I’ve also incorporated many of the charts I track into recent Market Snapshots videos. It’s time for an update.

First, I wear no blinders hiding the truth that the recovery in housing is not yet “healthy” relative to history. The housing market will continue to be hampered by anemic job growth, “underwater” homeowners and the foreclosure pipeline. But the forces of demographics and supply/demand imbalances have begun to register their weight and the data has done a great job of reinforcing our message from earlier this year.
Laws of supply and demand
Current conditions in the economics of housing reflect a considerable imbalance between supply and demand. Many chapters have been written about the supply part of the imbalance (i.e., overbuilding), but less ink has been spilled on the role of weak demand specific to declining household formations in since 2007. The National Association of Home Builders’ (NAHB) HousingEconomics.com division concludes that two-thirds of excess vacant housing units in the existing housing stock can be attributed to a steep decline in demand during the recession.

Household formations (e.g., adult children leaving parents’ households, singles leaving shared housing arrangements, etc.) are the largest component of demand for additions to the housing stock. These new households are accommodated by additions to the housing stock when vacancy rates are low, and are absorbed into the existing stock when vacancy rates are high. There’s a strong trend component to growth in the number of households, but formations are influenced by economic conditions—rising during good times and declining during bad times.

In the history of the data, the biggest declines in household formations occurred around recessions and bear markets. The 2010 drop in formations set a modern-day record, as seen in the chart below.
Boomerang Kids Moving Out of Parents’ Homes

Source: ISI Group, US Census Bureau, as of 2011. Household formations are calculated as the difference in households this year versus the past year.

A large gap is now developing as household formations surge from their recent base, while home completions lag behind. HousingEconomics.com suggests that a considerable portion of the excess housing supply (NY Fed president William Dudley recently estimated three million units) is due to a steep decline in demand related to economic conditions, rather than overbuilding. This has important implications: if excess housing supply was “pure” supply (i.e., assuming no pent-up demand), then recovery would take as long as it would take for demographic forces to catch up with supply. But, given that the excess supply embodies pent-up demand, then the recovery in housing will probably unfold more quickly than many believe.

Whether measured in terms of months’ supply or as a percentage of the working population, inventories of homes for sale have fallen dramatically since their peak. Inventories of single-family homes are down 24% from a year ago—the largest annual drop in at least 30 years, leaving inventories at roughly the historic levels that preceded the housing bubble. The number of homes for sale normalized for potential buyers (working age population) is now at a record low. This helps to explain the recent weaker home sales reports, which brought a few housing bears back out of hibernation. Existing home sales fell more than 5% in June to the lowest level in eight months. But, the prior month was revised up nicely and sales remain up more than 4% from a year ago. Looking deeper, the National Association of Realtors noted the decline in June was due to “tight supplies of affordable homes, limiting first-time buyers.” Another good sign is that despite weaker sales, median existing home prices shot up, reaching their highest level since September 2008. Real median home prices are up over 5% on a year-over-year trend basis, which is the most since March 2006, before the bubble burst.

Mortgage rates … get real!

Home prices are important for the obvious reasons, but also as an input into what I think is one of the most important housing metrics—the real mortgage rate. We’ve seen plenty of good news on the nominal mortgage rate front. The nominal 30-year fixed mortgage rate is now a record low 3.5%, but the “real” mortgage rate is even lower—in fact, it recently went negative.

Many long-time readers know that I pay more attention to the real mortgage rate (RMR) than the nominal mortgage rate. Just like real gross domestic product (GDP) is the difference between nominal GDP and inflation, the RMR is the difference between the nominal mortgage rate and the rate of appreciation (or depreciation) in median home prices. Why should we look at it this way? It’s not only the rate at which we’re borrowing that matters, but what’s happening to the price of the asset we’re borrowing to buy. See the chart below, which tracks the RMR back to the early 1970s.

Real Mortgage Rates Plunging

Source: FactSet, Federal Reserve, National Association of Realtors, National Bureau of Economic Research (NBER), as of June, 2012.

At the peak in the bubble, RMRs were -11% (6% nominal mortgage rate minus 17% appreciation rate). Fast-forward to the trough of the housing bust and RMRs had surged to 22% (5% nominal mortgage rate minus a 17% depreciation rate). No wonder the bubble burst: who would want to borrow at any rate to buy a rapidly depreciating asset? But today, RMRs are back in negative territory. It makes sense again to borrow to buy a house since home prices are now appreciating at a rate higher than the mortgage rate.

Surging housing market index

The NAHB/Wells Fargo Housing Market Index (HMI) is one of the most watched housing metrics and is based on a monthly survey of the National Association of Home Builders’ members. It gauges builder confidence about the single-family housing market and is a weighted average of market conditions for current new home sales, sales expectations for the next six months, and traffic from prospective buyers. As you can see in the chart below, there has historically been a tight relationship between the HMI and total home sales; and the latest jump is “forecasting” more sales to come.

Housing Market Index Suggests Higher Sales

Source: FactSet, National Association of Home Builders (NAHB), National Association of Realtors, US Census Bureau. NAHB Housing Index as of July, 2012. Total Home Sales (existing and new) as of June, 2012.

As an aside, I recently discovered (thanks to Wolfe Trahan) the relationship charted below, which compares the HMI (advanced 21 months) to the fed funds rate (which has effectively been zero since late 2008). Historically the two have been highly correlated. This should not serve as any kind of “warning” that the Fed will be raising rates sooner than it’s telegraphed (late 2014)—the Fed is making decisions on more than just trends in housing—but it will be something I am tracking.

Will Housing’s Recovery Alter Fed Policy?

Source: FactSet, Wolfe Trahan & Co., as of July 30, 2012.
Echo boomers to the rescue
I recently read the “State of the Nation’s Housing” report by the Joint Center for Housing Studies of Harvard University. In it was a discussion of demographics and I’ll conclude with some of their most interesting observations. “Assuming the economic recovery is sustained in the next few years, the growth and aging of the current population alone—including the entrance of the echo boomers into adulthood—should support the addition of about one million new households per year over the next decade.” The report also suggested adding at least another 180,000 to that estimate from immigration. Due to these demographic trends, it’s a decent bet that demand will continue to revive, even if job growth remains weak.

One of the concluding comments from the report was its most compelling: “The good news for housing production is that this new generation already outnumbers that of the baby boomers at the same ages. With even a modest lift from immigration, the echo boom generation will grow even larger as its members move into the prime household formation years.”
Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Copyright © Charles Schwab & Co., Inc.

Tags: Adult Children, Blinders, Charles Schwab, Chief Investment Strategist, Completions, Good Vibrations, Housing Market, Keeping Pace, Laws Of Supply And Demand, Liz Ann, Market Index, Market Snapshots, Mortgage Rates, Nahb, National Association Of Home Builders, Negative Territory, Rock Bottom, Senior Vice President, Steep Decline, Vacancy Rates
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Treading Water (Sonders)

Monday, July 30th, 2012

July 27, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
and Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research,
and Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key Points

• Volume has been low and stocks have managed to drift higher, despite some volatile days; but conviction appears to be lacking. We seem to be biding time until the action heats back up as summer winds down, but market-moving events can happen at any time.
• The US economy continues to slow and Fed Chairman Bernanke had a relatively dour outlook before Congress. But it appears things would have to get worse before another round of easing is initiated; the effectiveness of which we continue to question.
• Yields in Spain and Italy indicate action may be needed sooner rather than later, but we did get positive remarks by the ECB, which led to market rallies and a big drop in yields, providing a measure of hope. Meanwhile, Chinese growth has been hit by the global economic slowdown but their lack of transparency means getting a good read is difficult.

In contrast to the athletes in the Olympics that are laser-focused on moving forward and achieving their objectives, markets seem to be caught in a sort of summer malaise. Volume has been depressed and sentiment surveys show retail investor skepticism at high levels-despite stock market performance being relatively decent this year, with the S&P 500′s 8.5% gain through July 20 the best showing to this point in the year since 2000 (thanks to Wolfe Trahan & Co. Portfolio Strategy). But with policymakers lacking the discipline and focus of Olympic athletes (the understatement of the year), and continuing publicity hits to the financial sector, we can’t blame investors for their doubts; and determining what direction the next major move will likely be more difficult than usual. Whenever you get politicians and the courts involved in the financial picture, predictions become even more difficult than usual, and that’s saying something!

In this frustrating, unpredictable environment, we find it helpful to take a step back. Asset allocation continues to be important and investors need to pay attention to their distribution of money relative to their time horizon and risk tolerance. In this environment, investors ignore their portfolios at their peril as things can and likely will change quickly. We are unlikely to see any resolution to the fiscal cliff before the election and the eurozone crisis remains on tenuous footing; notwithstanding Mario Draghi’s encouraging comments (discussed below). But if you look out the five years that we suggest is an appropriate time horizon for equities, it’s difficult to imagine that we’ll still be dealing with these same issues. And US equities remain quite cheap based on historical measures and recently hit a cyclical high in terms of relative performance to most other global equity markets. Our view that the US market will be the best relative performer through at least the balance of 2012 has not changed.

Economy keeping its head above water—barely

The US economic picture continues pointing toward still (barely) positive but slowing growth. Somewhat concerning, however, was the third-consecutive negative reading on retail sales, the Philly Fed Index remaining in negative territory, and the Index of Leading Economic Indicators declining by 0.3% last month.

LEI paints a disappointing portrait

Source: FactSet, U.S. Conference Board. As of July 24, 2012.

However, there continue to be positive offsets that did not exist in either of the past two years when we also dealt with growth scares—dominant among them is the recovery in housing. We’ve seen steady improvement over the course of the year; but housing is now less than 3% of US gross domestic product (GDP) after hitting a high of over 6% at the peak in the bubble. The National Association of Home Builders (NAHB) Index rose 6 points to 35, still below the 50 mark that would denote a growing housing market, but the best reading since March 2007. Additionally, housing starts rose 6.9% to the highest level since October 2008.

Housing now contributing positively?

Source: FactSet, U.S. Census Bureau. As of July 24, 2012.

And although existing home sales posted a decline of 5.4%, the National Association of Realtors noted that the fall was attributable to inventory tightness, something that we haven’t heard in a while. In fact, there is now just a 6.6 month supply of existing homes for sale, versus 9.1 months a year ago. We’re not trumpeting the all-clear signal yet, but it appears to us that housing is now a help and not a hindrance to economic growth.

Additional support for our “muddle through” view comes from various other areas such as the Empire Manufacturing Index getting a modest bump to 7.4, industrial production expanding by 0.4%, and jobless claims remaining comfortably below 400,000. We are also through the bulk of earnings season and bottom-line results, while not spectacular, were largely better than reduced expectations. However, top-line growth was somewhat disappointing but consistent with the low level of nominal GDP growth.

Policy frustration grows

Unfortunately, much of the frustration expressed during earnings season was directed toward Washington. Politics has thrust itself into the middle of both the markets and the economy and cannot be ignored. Corporate executives are increasingly pointing toward the uncertainty surrounding regulation and tax policy as reasons that they were unwilling to take the risk of expanding their business or hiring new workers. And while companies often take shots at Washington, the difference this time around is the unanimity in the desires of executives. While each would likely have their own view on what the ultimate outcome would look like, the bottom line for the vast majority of them is that they need a bottom line. Businesses can adjust to a variety of circumstances—that’s one thing that has made America what it is—but they need to know the rules of the game. Unfortunately, Washington’s dysfunction and the typical antics in an election year suggest limited resolutions to what presently ails confidence and hiring.

Last week’s outrage was to hear a sitting Senator tell the Chairman of the Federal Reserve—after hearing again that the best thing for economic growth would be responsibly addressing the fiscal cliff—that the Fed better “get to work” because Congress was hopelessly deadlocked. And while Bernanke said the Fed is prepared to act again if necessary, our belief is that there is little they can do at this point to have a real impact on the economy.

Europe’s cliff draws nearer

Europe has leaned more toward collectivist fiscal policies than the US, which has helped to contribute to the ongoing debt crisis as governments have spent and promised beyond their means. At some point, bills have to be paid, and without strong incentives to take risks and expand business, payers start to dwindle while payees increase.

Currently, policymakers are again treading water but summer doldrums are noticeable in the peripheral sovereign bond auctions in Europe, where the few buyers that are showing up are demanding higher rates, particularly for Spanish and Italian government debt.

The risks for Spain remain high, with regional government debt and deficits the new concern du jour. Despite the 17 regional governments being major contributors to the 2011 deficit slip, the Spanish central government has been unable to control their spending due to strong cultural and historical adherence to regional autonomy. Regional government spending is significant, as they control education, health and social services, accounting for 50% of total government spending. The buyers’ strike for Spanish debt is intensified for regional governments, where the 10-year debt yield for the region of Catalonia exceeded 14% in June and the region of Valencia had to pay a punitive 6.8% six-month yield to roll over 500 million euros of debt in May.

As a result, yet another bailout fund has been created; this time for Spain’s regional governments, which Spain insists will not increase its borrowing burden. When adding to bank capital needs that were revised higher and deficit targets which were adjusted larger, investors are skeptical. This lack of confidence has resulted in Spanish government short-term yields spiking nearly as high as long-term rates, a sign of market stress, although we did see a marked pullback following the Draghi comments.

Spain’s stress gauge volatile

Source: FactSet, Tullett Prebon. As of July 26, 2012.

With Spain’s average maturity of 6.4 years resulting in a 4.1% average interest rate, rates may need to stay elevated longer before a bailout is necessary, but more forceful action is needed to contain the situation. The reason is that the size of Spain’s economy and government bond market is around double the combined size of those of Greece, Portugal and Ireland, and Spain’s problems have increasingly ensnared Italy.

Meanwhile, eurozone bailout funds are still impotent, with the temporary European Financial Stability Facility (EFSF) lacking sufficient funds, the permanent European Stability Mechanism (ESM) on hold for a ruling by the German Constitutional Court in September, and the European Central Bank (ECB) is not yet using monetary measures to solve what they view a fiscal problem. Despite recent comments by ECB President Mario Draghi indicating they would do “whatever it takes to preserve the euro,” actions are still lacking and their ability to implement substantial plans is likely severely constrained by their mandate and the continuing disagreements among member nations. While the market rallied on the comments and reminds us that sharp rallies are possible on potential positive movement, words have become less meaningful and more decisive action is needed.

We’ve said in the past that the situation is rife for outbreaks of market volatility, as we continue to see. Moody’s Investor Service apparently concurs, downgrading the outlooks for the AAA-rated nations of Germany, the Netherlands and Luxembourg. It was due in part to the rising risk of future liabilities, because policymaker’s “continued reactive and gradualist” response will “very likely be associated with a series of shocks, which are likely to rise in magnitude the longer the crisis persists.”

We’ve believed it would take severe market instability, nearing the edge of the precipice, before more forceful actions would be taken. The flattening of the Spanish yield curve indicates more forceful actions are drawing closer, with the ECB the institution able to respond most quickly. Granting the ESM a banking license could create large firepower, but Draghi said in July that this could risk the ECB’s credibility by behaving outside its mandate—seemingly conflicting with the above statement of unconditional support. Other “non-standard” measures such as restarting the Securities Market Program (SMP) for sovereign bond purchases were not discussed at the ECB’s July policy meeting, but traders are on the lookout for a change in the ECB’s stance.

Germany remains resistant to endlessly fund peripheral country problems, as it is responsible for the largest share of potential future liabilities. With Greece’s problems remaining, a Greek exit from the euro is not out of question. Conversely, there have been increasingly vocal suggestions that Germany leave the euro. While this is easier said than done and any action would have attendant costs, the ultimate decision is political, and therefore difficult to forecast.

All of the wrangling does have an outcome we can foresee—likely continued economic suppression in the eurozone; as uncertainty halts investment and spending, and a hobbled banking sector hampers lending. Additionally, the rollercoaster of investor sentiment is likely to remain, and we continue to believe European stocks will underperform most other global markets.

Chinese economic data manipulated?

China’s lack of transparency breeds speculation about where the economy is headed. Attention has focused on a significant slowdown in electricity production and consumption, which have fallen to single-digit rates in recent months, while gross domestic product (GDP) has slowed more modestly.

China’s electricity deviation historically “normal”

Source: FactSet, National Bureau of Statistics of China. As of July 24, 2012.

Electricity production has deviated from GDP in the past, not only in China, but also in other major economies, including the United States. This statistic is volatile and it is important to note that one of China’s major long-term initiatives has been to lower its energy usage per unit of GDP, and that energy-intensive industrial sectors have slowed more than the overall economy.

Positively, HBSC’s initial manufacturing purchasing manager index (PMI) for July rose to a five-month high of 49.5, driven by gains in production and export order components. We are skeptical China’s economy has yet to significantly accelerate, believing growth in China will slow further in the third quarter, but remain above a hard landing. Conversely, the Street is still grappling with the slowdown, forecasting a turn higher in third quarter growth 8.2% from 7.6% in the second quarter. A pick-up in fiscal and monetary stimulus is likely needed for China’s economy to reaccelerate, and the government thus far has been disappointingly slow and measured on this front.

With the desire to keep social unrest at bay, employment trends are likely closely monitored by Chinese officials. While not yet at a crisis level, the faster rate of contraction in employment indicated in the HSBC report, and comments from consumer-goods maker Jarden about a “halt” in wage inflation momentum, may indicate stepped up stimulus measures could be on the immediate horizon.

Spiking corn prices have ignited concern about food prices, in particular for emerging markets where the food component in consumer price inflation (CPI) indexes is two-to-five times larger than in developed markets, which could limit growth and continued easing by emerging market central banks. We are monitoring the situation, but aren’t yet ready to declare a lasting and broad increase in overall food prices, with prices of the important staple of rice still subdued. Read more international research at www.schwab.com/oninternational.

So what?

With such a conglomeration of concerns, investors can be tempted to throw up their hands in frustration and seek the perceived safety of a nice, comfortable mattress. However, as we saw with the Draghi comments, sharp equity rallies are possible and we believe at some time in the not-too-distant future resolutions to the two major issues—the eurozone crisis and the fiscal cliff—will emerge, setting the stage for a renewed sustainable move. Waiting until it occurs carries risks just as staying invested does, so we urge investors to maintain a diversified portfolio with a bit more exposure to the US side of the ledger at the expense of some European exposure. Valuations are attractive and sentiment is very pessimistic—a contrarian indicator. For tactical investors we would suggest adding to equities during pullbacks and trimming outsized positions during any fierce rallies.

This commentary originally appeared at Schwab.com

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Tags: BRICs, Charles Schwab, Chief Investment Strategist, Chinese Growth, ECB, Fed Chairman Bernanke, Financial Sector, Getting A Good Read, Global Economic Slowdown, Liz Ann, Olympic Athletes, Portfolio Strategy, Research Key, Retail Investor, Sector Analysis, Senior Vice President, Stock Market Performance, Summer Winds, Trahan, Treading Water, Understatement Of The Year
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Muddling Through…But for How Long? (Sonders)

Sunday, July 15th, 2012

July 13, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
and Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
and Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key Points

• Equity markets rebounded from their lows, but the move has been less than enthusiastic and convincing. Earnings season is upon us and corporate commentary and outlooks may take the focus away from the macro world—at least for a time.
• Muddling through is the popular phrase on the Street for what’s occurring in the US economy. But how long before a break is made one way or the other—both in the economy and the markets?
• Any progress made at the most recent European Union (EU) Summit appears to have been short-lived and any credible long-term solutions remain illusive. Additionally, Chinese growth continues to slow and concerns over a “hard landing” are growing.

Muddling through. Not the most inspiring phrase and we must admit that we are already tired of hearing it, even as we use it ourselves. But it appears to be the best description of what’s occurring in so much of the world currently. In Europe, policymakers continue to take one step forward, followed relatively quickly by one step back; avoiding a complete collapse, but really coming no closer to an actual resolution to their debt crisis and economic problems—muddling through. In China, growth has slowed and policymakers have been slow to respond and appear willing to accept a lower pace of improvement in exchange for deflating a real estate bubble and containing inflation—muddling through. And in the United States, stocks appear to be largely trading in a range, with neither the bulls nor the bears able to grab the reins and establish a trend; while economic data is mushy, but not overtly negative—muddling through.

The question is how long before the muddling stops and a sustainable direction is established? Unfortunately, while we believe a day of reckoning is drawing nearer and the ability of policymakers to use slight of hand to “fool” the markets into thinking solutions may be forthcoming is growing thin; it appears to still be at least a few months away, and the largely sideways action in stocks is likely to persist.

That doesn’t mean that investors who need to add to their equity exposure should wait until a definitive trend is established. By that time, much of the move will likely be passed and there is always the possibility of unforeseen events impacting the markets to a substantial degree—the so-called fat tail scenarios discussed in the last Schwab Market Perspective. For investors that have a time horizon of five years or longer, we continue to believe equities are attractive here. Valuations appear reasonable, but there are ample near-term hurdles, including the “fiscal cliff,” China’s growth, the US slowdown and the ongoing eurozone debt crisis. If the expectations hurdles have been set low enough , we could see some sharp rallies unfold among riskier asset classes, but there remain negative tail risks as well, and volatility and uncertainty are not likely going away in the near-term.

As we head into the peak of second quarter earnings season, corporations have the spotlight as the macro picture has entered a quieter zone. Judging by the elevated preannouncement ratio for the quarter, we expect to hear uncertainty and caution in the outlooks, as tax policy remains uncertain, the ultimate outcome in Europe continues to be illusive and China’s growth is slowing. With many companies having preemptively announced negative developments with their second quarter performance, expectations have been lowered, which would traditionally set up the possibility of upside surprises. However, we’re concerned that there may be further disappointments to come as the global economy continues to weaken. Regardless, it’s hard to imagine the corporate picture driving action for long as macro developments will likely again take hold as fall approaches.

Recession increasingly likely?

As mentioned above, the US economy appears to be muddling through, but concerns over a return to a recession have grown. Chief among the disappointing reports was the Institute for Supply Management’s (ISM) Manufacturing Index, which came in at 49.7, down from 53.5 and below the 50 level that denotes the dividing line between an expanding or contracting manufacturing sector. This was the lowest reading since July of 2009, but it’s important to note that the index traditionally doesn’t start to indicate recession for the broader economy until it drops below 44.

ISM indicates softness but no recession-yet

Source: FactSet, Institute for Supply Management. As of July 6, 2012.

More concerning was the new orders component-the more forward-looking part of the report-collapsing by 12.3 points, which was its biggest monthly drop since October 2001.

New orders are more concerning

Source: FactSet, Institute for Supply Management. As of July 6, 2012.

However, the service side of the ledger was a bit more positive. Although weakening, the ISM Non-Manufacturing Index remained above 50 at 52.1.

Additionally, the labor market continues to disappoint, although we do continue to see job additions. The ADP Employment report surprised on the upside at 176,000 new jobs for June but the broader government labor report was again disappointing, as only 80,000 new jobs were added. In contrast to the previous month, the unemployment rate remained unchanged at a still-elevated 8.2%. Remember, the unemployment rate is one of the most lagging of all economic indicators, and we have recently seen a positive reversal in unemployment claims, a leading economic indicator.

There are some automatic stabilizers that can help to stimulate economic growth when it slows. One that has been working quite well lately is the reduction in oil prices as demand growth has slowed, helping to put more money in consumers’ pockets. Additionally, other commodity costs have eased as well, although there is growing concern that the heat wave hitting much of the country is causing corn crop problems which has resulted in elevated corn prices. With corn used in so many food items, as well as in ethanol and other products, it is something we are keeping an eye on moving forward.

Government…muddling is thy name!

It’s difficult to imagine employers gaining a lot of confidence and willing to take additional risk by hiring a lot of new workers when they have so much uncertainty surrounding taxes, regulations and ongoing healthcare costs…exacerbated by the looming fiscal cliff. And while politicians on both sides of the aisle appear to recognize the problems this uncertainty is causing, definitive action still appears unlikely. At this point, we believe the most likely scenario is that the lame duck Congress following the elections will pass a three-to-six month extension of current policy so the new Congress can deal with it in 2013—thus avoiding the worst case scenario, but still leaving it hanging out there. One important note, however, due to the WARN Act, government contractors have to preannounce potential job cuts ahead of time. So if we still don’t have a deal before the election, we will likely have multiple mass layoff announcements made, especially from defense contractors, which could have a negative drag on sentiment.

Europe struggles to make progress

Speaking of a negative drag on sentiment, European policymakers have taken squabbling to an art form. More than two years into the sovereign debt crisis, progress remains disappointingly slow. Yet another European summit to curb the sovereign debt crisis has come and gone, and despite unveiling another “grand plan,” doubts remain, and muddling along continues.

The aim for the recent summit was to break the vicious cycle between weak peripheral countries and their weak banks. Low expectations were exceeded, but market relief was short-lived amid lack of details and still-missing components that are likely needed to quell the crisis. Meanwhile, each successive “grand plan” has had a shorter relief rally, as market participants are becoming less patient, while policymakers appear to lack urgency.

Market relief remains tenuous

Source: FactSet, iBoxx. As of July 10, 2012.

Spain remains a concern because its banking system needs capital, estimated at 37 billion euros by the International Monetary Fund (IMF), and 51-62 billion euros in stress tests conducted by consultants hired by the Spanish government. A separate audit on an individual bank-by-bank basis is due in late July.

The problem is the source of capital infusions for Spain’s banks:

• If banks are bailed out by the Spanish government, the Spanish government itself may need a bailout.
• One outcome of June’s summit potentially allows bailout funds to directly recapitalize banks. However, common eurozone-wide bank supervision is required first, and this is a complicated process that may not happen until the second half of 2013.
• The latest “plan du jour,” is to give Spanish banks 30 billion euros in emergency funding without expanding Spain’s government balance sheet. However, this stop-gap plan will not bolster confidence definitely in our opinion, as it not large or quick enough and lending nations remain resistant.

Incompatible cultures and politics hamper agreement on broad solutions and time has been wasted. As the debt crisis has become a crisis of confidence, each successive failure increases the risk that market confidence cannot be restored – once confidence is lost, it is difficult to gain back. From a long-term perspective, a break up of the euro remains an increasing possibility, which could improve the longer-term outlook, but would likely be accompanied by extreme volatility at the time of occurrence.

However, we don’t believe Europe will achieve either full union or break-up in the near-term, resulting in muddling through as the most likely scenario. As such, the rollercoaster loop of sentiment is likely to remain in place, and we continue to believe European stocks will be under-performers.

Global synchronized slowdown

The economic slowdown has gradually spread from Europe in the fall of 2011, to China in the first quarter of 2012, and now the United States appears to be joining. As a result, the JPMorgan Global Composite Purchasing Manager Index (PMI) shows global economic growth falling perilously close to contraction territory.

Global economy losing steam

Source: FactSet, Bloomberg. As of July 10, 2012.

A look under the hood is even more concerning, as the JPMorgan Global Manufacturing PMI has fallen to 48.9. The service economy has been a source of relative strength, but manufacturing has dropped, and manufacturing tends to lead economic trends, as it is more tied to the business cycle. Additionally, the new orders component of global PMIs dropped significantly in June, evident not only in the US ISM report mentioned earlier, but even China cited the United States as a new sign of weakness in June. Lastly, with inventories falling at a slower pace than orders globally, the implication is that an inventory destocking cycle could be upon us, which could result in lower economic activity in the future.

Is there a hard landing in China?

The gloomy sentiment stick appears to have been handed off from Europe, where slow growth appears to be “accepted” by markets, to China. The definition of a hard landing in China is debatable. We think of it as roughly a 3% decline from the potential growth rate of the economy, similar to the decline to zero growth in the United States. This would equate to roughly a 6% level for a hard landing in China, in our opinion.

If China’s gross domestic product (GDP) is still growing more than the 6%, what’s the fuss? We want to redirect the conversation away from “China hard landing” to the “stall speed” concept, where growth slows enough to become self-reinforcing. While an imprecise science, particularly in an immature economy, it feels to us like we are hovering around stall speed in China, much like we are in the United States.

We believe more fiscal stimulus needs to begin quickly to stave off the economic downturn in China. China’s response has been underwhelming thus far, either because growth hasn’t fallen enough, aging demographics have resulted in slower tolerable growth, the desire to not repeat prior mistakes and bubbles, or a desire to prudently allow steam to come out of the economy as it transitions to a consumer-based economy. Regardless, slower growth is likely to be the new normal for the Chinese economy in our view, a concept with which markets are still grappling.

China’s growth has global stock investment implications. Unrelated to economic growth, we believe the Chinese stock market has become less attractive over the intermediate term due to profit-reducing bank reforms, and the large weight of the financial sector in Chinese indexes.

However, we are still believers in the growth story of emerging markets (EM) as a group relative to developed markets. A more forceful fiscal stimulus in China has the ability to stimulate economic growth and stock performance in many Asian nations, which constitute the largest portion of the EM universe.

While a lot of negativity appears to be priced into EM stocks, the impact of the global slowdown is still being priced into developed market stocks, where earnings misses and negative stock reactions indicate that the extent of the weakness may not yet be priced in.

Lastly, we’d be remiss if we didn’t mention nuggets of good news, including inflation falling globally, a change in attitude from austerity to growth, and global central bank easings. Our base case is a global slowdown, not a crash, and investment opportunities remain. Read more international research at www.schwab.com/oninternational.

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Tags: BRICs, Charles Schwab, Chief Investment Strategist, Chinese Growth, Collapse, Debt Crisis, Earnings Season, Economic Data, Economic Problems, European Union, inflation, Liz Ann, Long Term Solutions, Lows, Macro World, Outlooks, Real Estate Bubble, Reins, Research Key, Sector Analysis, Senior Vice President
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Our House: Is the United States the Best House in a Bad Neighborhood? (Sonders)

Wednesday, June 6th, 2012

June 4, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• The June 1 employment report was a dud, but other economic reports were a bit rosier.
• The eurozone debt crisis and slowing global growth remain the greatest risks.
• A muddle-through economy continues to be the most likely path.

I won’t try to put lipstick on the pig that was last Friday’s May jobs report, but I will try a little lip gloss. Somewhat lost in the mire of the dire reaction to the report were several other more-positive readings on the economy. That’s testament to the likelihood that there are many more drivers to today’s malaise than just jobs growth, or lack thereof. It seems clear we’re in the midst of the third consecutive mid-year economic slowdown, driven by similar forces, most dominantly the eurozone debt crisis.

Questions about recession risk are as rampant now as they were last fall, but I remain in the camp that believes we will avoid one in the short-term. Part of the reason is not rosy: as the saying goes, if the plane never got off the runway, a crash is much less likely. It’s the “blessing” and the curse of a muddle-through economy. I wouldn’t bet the farm on a recession being avoided and I have as cloudy as crystal ball as anyone, but that remains my view.

First, the lip gloss

The weakness in the employment report was largely across the board. Payroll employment was up a meager 69,000, about half the consensus expectation, while the unemployment rate ticked up a tenth to 8.2%. The weakness was largely concentrated in three areas: business services, leisure and hospitality, and construction.

The weakness in construction probably reflects a “give-back” from the exceptionally strong, warm-winter-weather period in the beginning of the year. The other two segments tend to see their hiring lag movements in energy prices, and given their surge during the first four months of this year, the weakness is not terribly surprising. The good news is that energy prices have plunged since then.

There are some other caveats, too. The household measure of employment, from which the unemployment rate is derived, showed an increase of 422,000 and an increase in the number of participants in the labor force. The latter explains why the unemployment rate ticked up, but may also show some increased confidence about landing a job. However, it also points to expiring unemployment insurance benefits, which is forcing some participants back into the labor pool.

It’s not all bad

We also know that many of the leading indicators for job growth remain healthy, including:

• Employment components of the Federal Reserve’s regional manufacturing surveys
• Hiring plans, sales, profits and jobs-hard-to-fill at multi-year highs
• Jobs-hard-to-get at multi-year lows
• Job openings (JOLTS survey) at a four-year high
• Average hours worked at a 20-year high
• National Federation of Independent Business plans to hire at a cycle-high

Friday also brought the latest Institute for Supply Management (ISM) manufacturing index, which registered a reading of 53.5—still well above the 50 reading that separates an expansion from a contraction, and consistent with economic growth remaining comfortably above recession territory. On top of that, the new-orders component of the ISM index (both the index overall and the new orders component are key leading indicators) is not only at a cycle-high, but the “prices paid” component, measuring inflation, has collapsed in the past month. As noted by Wolfe Trahan, the best US gross domestic product (GDP) readings have generally come in the wake of large declines in inflation. And stocks generally do well when leading indicators of growth (new orders) are stronger than inflation pressures (prices paid).

Wall of worry is back

Sentiment has also improved markedly over the past month, thanks to May’s weakness. When I last wrote about sentiment in early April we highlighted the market’s elevated risk of a correction due to overly-optimistic sentiment (a contrarian indicator). As you can see below, that sentiment has reversed and is approaching territory that’s usually supportive for stocks. But frankly, I’d feel better if sentiment got even more pessimistic. We may need to see a little more capitulation before the market can find its legs.

Enough Pessimism?

Source: FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of May 29, 2012.

Manufacturing renaissance

Longer term, we remain optimistic about the prospects for both the US economy and stock market relative to the rest of the globe. As I’ve noted consistently, we have a “renaissance” story unfolding here in the United States; particularly within manufacturing and domestic energy. Housing is also becoming a major tailwind (more to come on that in future reports.)

I got back from a trip to China 10 days ago and my conversations in Hong Kong and Shanghai largely supported my view that even in the face of a “muddle through” economic-growth environment, from which this country is unlikely to exit any time soon, there are bright spots worthy of attention. In fact, maybe tellingly, nearly everyone with whom I had a conversation was more pessimistic than the consensus about China’s growth prospects but more optimistic than consensus about US growth prospects. And this was the sentiment of both local Chinese as well as US ex-patriots with business in China.

Tags: Bad Neighborhood, Blessing And The Curse, Charles Schwab, Chief Investment Strategist, China, Crystal Ball, Debt Crisis, Dud, Economic Reports, Economic Slowdown, Employment Report, Energy Prices, Eurozone, Global Growth, Last Friday, Liz Ann, Muddle, Payroll Employment, Senior Vice President, Unemployment Rate, Warm Winter Weather
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It’s All Relative (Sonders)

Monday, June 4th, 2012

June 1, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc., and
and Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and
and Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key Points

• Equities have pulled back and are flirting with correction (-10%) territory. We believed this was a needed process, and remain modestly optimistic that economic data will rebound and the market will eventually resume its move higher over the next several months.
• The Federal Reserve has made clear that it stands ready to act should the US economy deteriorate, or the European debt crisis escalate, but we remain skeptical. The more important issue in our view is how the coming “fiscal cliff” is addressed.
• The European crisis continues to escalate and we are recommending that investors underweight European equities. Hopes of a sustainable solution in the near term are virtually nonexistent, while contagion fears are rising. China’s growth has slowed but the country has tools at its disposal and we believe a soft-landing is the most likely scenario.

Frustrating! That’s one of the most common words we hear from investors as they look at the current environment. Fixed income yields remain historically low, money market returns are nonexistent, international markets have various ills, and the domestic economy is muddling along—not a great list to choose from.

As uncertainty has grown, we are again reminded how important having a diversified portfolio can be. Day-to-day moves can be influenced by innumerable factors that are rarely predictable, and even over several months, markets can be influenced by exogenous events that are nearly impossible to appropriately factor into pricing models. For example, at what discount should equity markets trade if Greece exits the eurozone? We don’t know if it will happen, when it might happen, how it will happen, or what the ultimate financial impacts may be. We don’t know if there will be a relief rally or a sharp downturn on further uncertainty—both arguments can be made. And, of course, the market could move in the exact opposite direction if an agreement to keep Greece in the coalition is reached and viewed as credible by investors. As detailed below, risks in the eurozone have risen to the point that we are now recommending investors underweight European equities, which results in an underweighting of developed international, and use that cash to move to a potentially more defensive posture by investing in highly-rated US equities.

We continue to see signs, however, that many investors are overexposed to investments viewed as “safe.” Highly-rated fixed income instruments continue to see near-record inflows and cash appears to be heavily weighted in many investors’ portfolios. This “return of capital rather than return on capital” mentality, however, has its own dangers. By holding an outsized amount of a portfolio in these instruments that are paying next-to-nothing in yield, investors are virtually locking in losses of purchasing power at even a low inflation rate of 2-3%. To achieve investing goals over the longer-term, we believe investors need to be appropriately allocated among various asset classes, which may mean moving into areas that are not exactly comfortable and where clarity is lacking.

US looks good—relatively speaking

We believe that domestic equities are among the most attractive assets currently. We’ve seen a pullback that has come close to correction territory (down 10% from the top), which has helped to alleviate some of the overly optimistic sentiment indicators that we highlighted in early April. The American Association of Individual Investors (AAII) recently noted that its bullish reading is now at the lowest level in 20 months. The pullback has also helped to bolster the valuation picture as earnings remain healthy. In fact, on a forward-earnings basis, the multiple on the S&P 500, at 12, is four points lower than the long-term average of 16.

Economically, domestic data has been a bit soft, but several areas—notably autos and housing—have improved; and US growth is decidedly stronger that in many other areas of the world. The mild winter likely had an impact on data, and we are likely seeing a little give-back recently; but we think the risk of another recession in the near-term is low. Although unemployment claims are no longer descending at the same pace as earlier this year, the labor market continues to heal. The May labor report was disappointing but we don’t want to panic over one or two weak numbers from a lagging indicator. However, the mere 69,000 jobs gained in May along with a tick up in the unemployment rate to 8.2% is certainly concerning and the next several weeks of data will be key to watch.

Claims have shown strength after soft patch

Source: FactSet, U.S. Dept. of Labor. As of May 31, 2012.

As noted, we’ve seen increasing signs that the housing market is slowly starting to heal. While its impact on the economy has dramatically fallen over the past several years, an even modestly improving market should help to bolster confidence and stimulate activity in various areas of the economy. The National Association of Home Builders confidence reading rose to 29 recently, still quite low, but the highest reading since May 2007. Additionally, we saw housing starts rise 2.6% month-over-month (m/m), new home sales gain 3.3% m/m, and existing home sales advance by 3.4%. Perhaps even more encouragingly, the median price of those existing homes rose 10.1% year-over-year. Finally, housing affordability remains at an all-time high thanks to still-low prices and record-low mortgage rates.

Tags: Brazil, BRICs, Charles Schwab, Chief Investment Strategist, Contagion, Debt Crisis, Diversified Portfolio, Domestic Economy, Economic Data, energy, European Equities, Eurozone, Exogenous Events, Federal Reserve, Fixed Income, Ills, India, International Markets, Liz Ann, Money Market, Pricing Models, Sector Analysis, Senior Vice President, Sustainable Solution
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Month of May: Sell and Go Away, or Hang in There? (Sonders)

Tuesday, May 15th, 2012

May 14, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• We believe the stock market’s correction is likely to be less severe this year relative to 2010 or 2011.
• Be aware of the possible perils of following a “sell in May” trading strategy.
• For now, macro concerns—including Europe and the looming “fiscal cliff”—are trumping better micro news.

The stock market is in correction mode and investors are on edge. There are likely several reasons for the weakness, including what we pointed out in our early-April report on elevated optimistic sentiment. Since sentiment tends to work a contrarian magic on the market, we were anticipating a period of consolidation after the stellar six-month, 30% run off the early October 2011 low—and we’re getting it.

Of course, we’re also yet again dealing with the eurozone debt crisis, but also choppier economic indicators in the United States recently, a volatile election season and concerns about the so-called “fiscal cliff” heading into the end of this year. But one of the questions I’ve gotten most often recently has been about the seasonal phenomenon called “sell in May and go away,” and whether the market’s in store for another summer swoon like we’ve had the past two years.

Macro trumping micro

I’ll start with “sell in May,” but before I do, I want to address an important general observation. As we’ve noted many times recently in reports and media appearances; and as detailed in a terrific recent report by Wall Street research firm Wolfe Trahan, macro is trumping micro. One of the reasons for this is the decline in guidance investors are receiving from company managements.

In the past, guidance was often an anchor of reason in volatile times. Events like European elections or spiking eurozone sovereign bond yields might not have been such big market-moving events when we could rest on US companies’ guidance as to the future. Add to that rapid-fire trading, shortened time horizons, greatly increased access to information, greatly increased speed of news’ dissemination, and much more globalized economic and financial systems, and you have a recipe for increased volatility around macro events.

Sell in May?

Much is made every year of the “sell in May” phenomenon. Its basis is rooted in the fact that the best performance for the market has generally come in the November through April period, while the worst has come between May and October.

There is some truth to the adage. According to data compiled by Ned Davis Research (NDR), through the beginning of May this year the average performance for the period from May 1 through October 31 each year since 1950 was 1.2%. The average performance for the period from November 1 through April 30 each year since 1950 was 7.0%.

As compelling as those numbers may seem, there are many things to consider, especially if it’s your inclination to develop a trading strategy around those seasonal patterns. First, the calendar months individually tend to fall into either the “hot” or “cold” columns for performance, as you can see in the table below. Three of the six months that fall into the “all out” period spanning from May through October are actually historically strong months, while three of the six months that fall into the “all in” period spanning from November through April are actually historically weak months.

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of 1928-April 30, 2012.

As you can see, all of the seasons seem to be adequately represented in both columns. And what we know for a fact is that time horizons have become much shorter over the recent years, and the reaction function gets triggered more often. It’s likely that many investors may find their patience tested when experiencing either a great month (or two) during the May-October “all out” period and/or a poor month (or two) during the November-April “all in” period. Of course, the seasonal trading strategy must consider transaction costs and tax implications.

Sector performance May-October

For investors who like to take a tactical approach to the seasonal tendencies, a sector bias strategy may be worth considering. Before I get to the details, let me remind our clients that we moved toward a more sector-neutral strategy back in early April when we became more cautious about the market in the short term. Presently the only outperform rating we have is on the information technology sector, while the only underperform rating we have is on the utilities sector.

As you can see in the table below, courtesy of The Leuthold Group, cyclical groups have tended to outperform during the market’s traditionally strong November-April period, while defensive sectors have been the relative winners during the customarily weaker May-October period. In fact, the size and persistence of these effects have been impressive (at least since 1989, the span of the analysis).

S&P 500 Sector Seasonality

Source: The Leuthold Group, October, 1989-April, 2012. Defensive sectors: consumer staples, health care and utilities. Cyclical sectors: consumer discretionary, industrials and materials.

Buy in May in election years?

There’s also the rub of this being an election year, during which sitting out the May through October period has historically not worked well. Using the Dow Jones Industrial Average because of its longer history, the market has been up 4.5% during election years in the May-October span versus 2.6% for all years (including election years). And for what it’s worth, according to NDR, the market has bucked seasonal weakness even more when the incumbent president has won, with a median gain of 7.6% versus 0.5% when the incumbent president has lost.

NDR provides a clue as to why this is the case: A correction has occurred during the second quarter of election years, on average (sound familiar?). But the correction has tended to be concentrated in the second quarter, setting the stage for a summer rally.

2012′s positive offsets to present weakness

I actually think the scenario noted above is more likely than not this year. Muscle memory has many investors fretting a repeat of 2011 and 2010, when economic weakness in the spring led to brutal corrections each year, to the tune of -19% and -16%, respectively. But there’s a long list of positive offsets this year relative to the past two years:

• Inflation is coming down, especially among commodity prices.
• Credit growth is quite strong, especially for consumers.
• Housing has improved markedly.
• The US manufacturing sector is humming.
• NFIB’s small business survey made recent upside breakout.
• Job growth is much better.
• Consumer confidence is improving.
• Private-sector leverage ratios are much improved (debt servicing costs are extremely low).
• Recovery in state/local government spending.
• The US economy somewhat decoupling from rest of world; at least Europe.
• US bank capital/health is much better than Europe’s.
• The European Central Bank’s Long-Term Refinancing Operations have reduced likelihood of global financial contagion.
• Germany appears more willing to accept higher inflation, opening the door to easier monetary policy for the eurozone.
• Valuations are quite cheap, especially on forward earnings.
• Investor sentiment has improved sharply with the correction to-date (meaning pessimism has kicked back in).

I don’t think the present correction is over, but do believe it could be kept to within the normal 5-10% range. Since the current bull market began in March 2009, the S&P 500 has had 15 corrections of more than 5% that were preceded by at least a 5% rally (consistent with this year’s pattern). The table below highlights their duration and ultimate percentage drop.

S&P 500 5% Corrections

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of May 11, 2012.

Wall of worry being rebuilt

Tempering my short-term concern has been the aforementioned improvement in sentiment conditions. That said, I think there’s likely a bit more pessimism needed to establish a short-term bottom for the market. As you can see, the well-watched NDR Crowd Sentiment Poll (CSP) has moved decisively lower, but not yet to the extreme pessimism zone:

Bye-Bye Optimism

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as May 8, 2012.

NDR noted in a recent report several key reasons to expect the correction to be within the normal 5-10% range:

• Initial reversals in CSP extremes are consistent with median declines of about 8% within six months.
• The first half of election years have shown median declines of just less than 10%.
• Once “pre-waterfall” highs have been exceeded, as occurred in February of this year, median market declines have ranged between -3% and -7% within six months.

Saving the worst for last

I think investors and the media may be underestimating the impact the coming “fiscal cliff” is having on market and business psychology. The fiscal cliff refers to the near-simultaneous January 2013 expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester (automatic spending cuts) established in last summer’s debt-limit agreement.

The range of estimates for its ultimate impact are, unfortunately, quite wide. The lowest estimate I’ve seen comes from NDR, using Congressional Budget Office assumptions, with the impact at a relatively “low” 2.4% of US gross domestic product (GDP). Most estimates tend to cluster around 3.5% of GDP.

It’s impossible to know what’s right because different assumptions are being used. But the consensus is closing in on a worst-case scenario of about 4% of GDP. ISI recently put the numbers into three distinct buckets, each with about $200 billion of impact:

1. Provisions likely to create a fiscal drag (approximately (≈) $221 billion or 1.4% of GDP):
   • Cuts to discretionary spending (≈$84 billion)
   • Tax increases on upper-income Americans included in the Affordable Care Act (≈$21 billion)
   • Payroll tax cut (≈$116 billion)
2. Bush tax cuts (≈$200 billion or 1.3% of GDP, although likely impact would be spread over several years)
3. Items unlikely to be allowed to take affect and thus aren’t likely to create a fiscal drag (≈$179 billion or 1.1% of GDP):
   • Huge increase in number of Americans paying the alternative minimum tax (≈$94 billion)
   • Sequester cuts (~$85 billion)

There are three additional items that don’t fall neatly into ISI’s three buckets, including tax extenders, extended unemployment insurance benefits and the “doc fix,” which would together total about $75 billion. These items are not expected to create a significant fiscal drag.

I actually think this is having a larger impact on psychology than many believe, especially on the confidence of corporate leaders and their ability to plan (and guide Wall Street’s analysts) for the future.

Muscle memory may fail us this year

In sum, there’s much to fret about, and volatility is likely to remain elevated until this correction has run its course. But a lot has changed in the past two years—much for the better—particularly for domestically oriented US companies. There’s at least a little bit of decoupling underway, certainly between the United States and Europe, and that’s likely to assist in keeping the correction from mirroring the ones in 2010 and 2011.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Tags: Anchor, Bond Yields, Charles Schwab, Chief Investment Strategist, Debt Crisis, Economic Indicators, Election Season, European Elections, Liz Ann, Media Appearances, Micro News, Perils, Seasonal Phenomenon, Senior Vice President, Sentiment, Stock Market, Swoon, Trading Strategy, Trahan, Volatile Times
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Panic Is Not a Strategy—Nor Is Greed (Sonders)

Monday, May 14th, 2012

Panic Is Not a Strategy—Nor Is Greed

Updated May 10, 2012
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• Originally publishing in 2008, it’s time for a refresher about the perils of panic.
• Asset allocation, diversification and rebalancing are as close to a “free lunch” as you can get as an investor.
• In a world where time horizons have shrunk precipitously, think longer-term.

If markets are good at one thing, it’s reminding investors that they don’t go up uninterrupted forever. We witnessed several bruising corrections in 2011 before the market’s strong rally between October 2011 and April 2012. As the chart “Fear Spikes Again” below illustrates, the CBOE Volatility Index® has picked up again, but remains below the unparalleled heights of the 2008 credit crisis and the more-recent elevation in 2011.

Fear Up, But Well Down From Highs

Source: FactSet, as of April 20, 2012. The CBOE Volatility Index (“VIX”) is a registered trademark of the Chicago Board Options Exchange. The VIX Index shows the market’s expectation of 30-day volatility. For more information on the VIX, visit www.cboe.com/micro/vix/

We’re always quick to remind investors that neither panic nor greed is an investment strategy, and that the best foundation to help protect a portfolio against the unpredictable is having—and sticking with—a long-term strategic asset allocation plan.

Mindset matters: strategic trumps tactical

In reality, investors should rarely, if ever, react to a dramatic short-term move in the market. As intriguing as it may seem to try to catch bottoms and get out at tops in order to reap big profits (or so you think), the “tactical” (or shorter-term) approach to investing has its limitations … and its risks.

We believe it’s the “strategic” asset allocation decision—and the ability to stick with it through the discipline of rebalancing—that will ultimately reap the greatest rewards. These decisions are not a function of short-term market gyrations or forecasts (mine, yours or anyone else’s), but are tied to your risk tolerance and long-term goals. Developing and maintaining the right long-term asset mix is by far the most important set of decisions a client will ever make.

Never before has information about the global economy and markets been more readily available and disseminated. As a result, global markets have become very interconnected. In turn, our reaction mechanisms have kicked in, and investor time horizons have shortened dramatically—but not necessarily to our advantage. Yes, the long term is really just a series of short-term events, but it’s how we react to them that decides our ultimate fate as investors.

Asset allocation and diversification: investors’ “free lunch”

One of the most important areas where Schwab offers advice is the development of a long-term strategic asset allocation plan. Many investors assume that their position along the risk spectrum from conservative to aggressive is largely based on their age and time horizon. But a more important factor is their risk tolerance. Also important is judging the difference between an investor’s financial risk tolerance (their ability to financially withstand volatile markets) and their emotional risk tolerance—a spread that’s often quite wide and only acknowledged during tumultuous market environments.

I’ve known plenty of older investors who thrive on the risk associated with an aggressive investment stance. I’ve also known plenty of young investors who can’t stomach any losses. Too often, investors use a rearview mirror to make their investing decisions, by looking at past performance as a guide to future results. A mirror is a valuable tool but only when turned on yourself to judge your own circumstances—tolerance for risk, time horizon, income needs, etc. As I’ve often said, there are very few free lunches in investing. Asset allocation, diversification and periodic rebalancing are as close as you get.

Risk tolerance: Know what you can stomach

In the chart “Schwab’s Strategic Asset Allocation Models” below, you’ll see our long-term recommendations regarding different asset classes for three types of investors: conservative, moderate and aggressive.¹ Note the vast differences in allocations to riskier asset classes, including international equity, as you move up the risk spectrum.

Clearly, over the long term, given the better performance by the riskier asset classes, a more aggressive allocation has historically reaped higher rewards in terms of returns. But there is a dark side to an aggressive posture’s higher returns—the risk taken in getting there.

Tags: Allocation Plan, Cboe Volatility Index, Charles Schwab, Chicago Board Options, Chicago Board Options Exchange, Chief Investment Strategist, Credit Crisis, Diversification, Free Lunch, Greed, Investment Strategy, Liz Ann, Perils, Rewa, Senior Vice President, Strategic Asset Allocation, Term Approach, Time Horizons, Unparalleled Heights, Vix Index, Volatility Index Vix
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Here We Go Again….or Not? (Sonders)

Sunday, May 13th, 2012

Here We Go Again….or Not?

May 11, 2012

by Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
Brad Sorensen
CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and,
Michelle Gibley
CFA, Director of International Research, Schwab Center for Financial Research

Key Points

• Softer economic data has prompted concerns that the market may be headed for a summer swoon—similar to the previous two years. We believe the backdrop is decidedly different (and better) this time around but investor and business confidence will continue to be important.
• Some appear to be hoping for weaker data in order to spur the Fed to enact another round of quantitative easing (QE3). We believe the bar is much higher and that the Fed should look to return to a more normal monetary stance. Complicating the overall picture and the Fed’s job is the coming “fiscal cliff” out of Washington at the end of this year.
• The political situation in Europe has injected even more uncertainty into an already tenuous environment. Public cries for a reduction in austerity, despite many proposed measures not taking affect yet, raises questions as to the sustainability of the eurozone as is. Spending cuts are important, but must be accompanied by serious structural changes that encourage growth and innovation to provide hope for the future.

NOTE: The next Schwab Market Perspective will be published one week later than normal—June 1, 2012.

We’ve seen this movie before … or have we? After starting out the previous two years in a positive direction, stocks experienced disappointing downturns beginning around this time of each year and continuing throughout the subsequent summers. Recently we’ve seen economic data soften, global concerns rise, Treasury yields fall, and stocks correct, prompting more questions as to whether we’re seeing a very unwelcome sequel. We believe not.

Before getting into why we don’t believe we’re in store for Summer Swoon III (a sequel, like many, that no one wants to see), we want to again point out that trying to time the market is largely a losing game for investors. And we also continue to remind investors that sticking to a disciplined long-term plan is key, rather that chasing crowd psychology or past returns. We’re reminded of the continued chasing mentality that almost inevitably leads to disappointment as ISI Research reported that bond mutual fund inflows were at a record high during the first four months of the year, while equity fund outflows were the third largest on record.

Currently, investor apprehension is rising, indicated by increasing volatility and a stock market in correction mode, as the possibility of a replay of the previous two years is considered. However, we believe there are several important fundamental differences that help to support a renewed market advance before too long. First, we aren’t dealing with any major natural crises such as the Japanese earthquake and tsunami we saw last year; or the spike in food inflation that unleashed the “Arab Spring.” In fact, commodity prices are largely moving lower, allowing central banks around the world to ease monetary policy, as we’ve seen in Brazil, Australia, and India among others. And while there are still major concerns regarding the debt crisis in Europe, discussed in further detail below, the European Central Bank (ECB) has made moves that indicate they will be aggressive to preserve some semblance of stability in the European markets. Finally, in the United States we’re seeing further signs of housing stabilization, a continued improving job situation, and a rebound in auto sales, which is now a larger driver of GDP than residential investment.

But there’s the impact of “muscle memory” given the past two years’ volatility; and perception can become reality. There is a risk that investors increasingly lose confidence in the economic recovery, pressuring stocks, and causing businesses to again pare back. In the short term, market performance can have more to do with sentiment than fundamentals, again illustrating the folly of short-term timing.

Temporary Softness or a New Trend?

Data has been mixed lately, with regional manufacturing surveys largely disappointing: the Chicago PMI fell to its lowest level since November 2009, although remaining in expansionary territory and the Dallas Fed Index slipped into negative territory. The national index provided more encouragement as the ISM Manufacturing Index rose to 54.8, the best level since June 2011, while the forward looking new orders component rose to 58.2, the best level since April 2011. This is distinctly better than the trend in most global PMIs. However, more concern came in the form of the ISM Non-Manufacturing Index, which softened to 53.5 from 56. But while the important service sector showed some softness, we continue to see consumers improve their balance sheets, which should help to support spending going forward.

Consumers’ debt position is much improved

Source: FactSet, Federal Reserve. As of May 7, 2012. Includes mortgage and consumer debt, auto lease payments, rental payments, homeowners insurance, and property tax payments.

Key to consumer spending continuing to hold up is likely the continued improvement in the job market, which has been in question lately. Jobless claims started to creep higher before experiencing a relatively sharp reversal recently and remaining well below the critical 400,000 level. However, payroll growth continued to be disappointing as a soft reading for March was followed with another one in April. We saw ADP report a mere 119,000 private jobs were added, while the Bureau of Labor Statistics (BLS) reported that nonfarm payrolls expanded by a weak 115,000 positions; although the previous two months were revised higher. The unemployment rate fell to 8.1% due largely to a drop in the labor participation rate, which now stands at 63.6%—the lowest level since 1981.

Tags: Austerity, Backdrop, Brazil, BRICs, Business Confidence, Charles Schwab, Chief Investment Strategist, Economic Data, Eurozone, Global Concerns, Liz Ann, Market Perspective, Monetary Stance, Political Situation, Positive Direction, Research Key, Sector Analysis, Senior Vice President, Sequel, Sustainability, Swoon, Treasury Yields
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Roller Coaster Returns (Sonders)

Wednesday, May 2nd, 2012

April 27, 2012

After an extended, and almost unprecedented period of relative calm, resulting in robust stock market gains from October 2011 through March 2012, we have seen some volatility return. Concerns over global growth have reemerged as Chinese economic data has disappointed, the European debt crisis again is gaining headlines as the merits of austerity are being questioned, and US economic data has been less impressive.

Volatility has picked up

Source: FactSet, Chicago Board of Trade. As of Apr. 24, 2012.

One potential benefit of this rise in consternation has been the long-awaited correction in stocks that many had been calling for. In fact, we have been comforted by numerous investor sentiment readings now showing elevated bearishness (remember that investor sentiment is a contrary indicator). The American Association of Individual Investors’ (AAII) bull ratio recently moved decidedly below the 50% mark for the first time in 2012. The percentage of respondents saying they are bearish has moved from just under 28% to nearly 42% between April 4 and April 11; and the percentage of bulls dropped to 28% from over 38% over the same time period. We believe this change in sentiment was needed in order for the market to reestablish a sustainable uptrend going forward.

The recent mild increase in volatility again reminds us that it’s important to maintain a long-term focus and to maintain a diversified portfolio. It’s vital that investors review their portfolio holdings on a regular basis, while also looking at how correlations among asset classes change over time. A well-diversified portfolio in one year may not be nearly so two years later, even if the positions are roughly the same—the interaction between asset classes changes over time. One final note on portfolio construction: The drumbeat of bearish bond commentary has grown over the past month as yields remain near record lows. While we again remind investors that investing in bonds for speculative or capital appreciation purposes has become more risky; it is also true that for diversification, income, and capital preservation purposes, bonds will still have a valuable place in many portfolios. Again, balance is the key.

Macro concerns again trumping micro story

Investors’ attention is again focused on the macro rather than the micro over the past couple of weeks—the height of first quarter earnings season. The reporting period has been much better than expected, although admittedly from a lower bar—83% of companies have beaten expectations so far, which is an all-time record high. But market reactions to good reports have been more muted relative to the punishments doled out to those that disappointed. It appears Chinese developments, European debt and growth concerns, and some softening in US economic data has led to increased volatility.

In the United States, the economic expansion continues, but we may be in yet another soft spot. This isn’t surprising given the likely pulling forward of some economic activity that was influenced by the unusually warm weather during the winter months. We believe this is a relatively modest and temporary phenomenon and that activity will again pick up in the coming months. Concern has grown that 2012 will be a repeat of the previous two years when the market declined beginning in April on softening economic data after decent starts to the year. We believe the story is different this time as jobs, lending and housing have improved and inflation has eased, allowing global central banks to keep policy loose; leading to our view that history won’t repeat this year.

Recently, we’ve seen regional manufacturing surveys disappoint, although remaining in territory depicting growth. The Empire Manufacturing Index fell from 20.2 to 6.6 and the Philly Fed Index dropped to 8.5 from 12.5. Encouragingly, the employment expectation component of Philly Fed jumped six points to its highest level in a year, while March retail sales increased 0.8%, above estimates, indicating that the American consumer remains engaged. Commodity costs have also leveled off recently, which should help to bolster discretionary income.

Lower commodity prices should help consumers

Source: FactSet, Standard & Poor’s. As of Apr. 24, 2012.

Despite this still-positive picture, recent job and housing data has weakened a touch. The March payroll report disappointed despite the unemployment rate dropping and recent initial jobless claims have crept a bit higher. We remain relatively unconcerned given that seasonal adjustments around the Easter holiday can be difficult and the level still remains well below the key 400,000 number. Jobs are a vital cog in the economy and we believe that increasing retail demand and a declining ability of companies to squeeze additional productivity out of existing workers should allow for continued improvement on the labor front.

Tags: Austerity, BRICs, Charles Schwab, Chicago Board Of Trade, Chief Investment Strategist, Dangerous Game, Debt Crisis, Earnings Season, Economic Data, Economic Forecasts, Election Season, Fed Meeting, Global Growth, Investor Sentiment, Liz Ann, Relative Calm, Roller Coaster, Sector Analysis, Senior Vice President, Stock Market Gains, Unprecedented Period
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