Why are equities doing so well?
U.S. equity returns were robust in the third quarter with the S&P 500® Index increasing 6.35%, the Russell Midcap® Index up 5.59%, and the Russell 2000® Index up 5.25%. These positive returns erased all of the second quarter declines, putting these indexes solidly into positive territory with returns in excess of 14% for the year.
Many pundits believe that the strong performance of the third quarter was driven solely by the Federal Reserve’s policy of what many are calling “QE Infinity.” Markets are not quite that simple. The recovery, which started in March 2009, has not behaved like your typical post-recession recovery. The third quarter was no exception.
U.S. manufacturing data weakened, undoubtedly influenced by Europe’s recession and the slowdown in China, while U.S. business uncertainty over hiring and investing has been amplified by the uncertainties of the impending election and Washington’s inability to reach consensus on how to resolve the “fiscal cliff.”
Given these challenges, why are stocks continuing to do so well?
Several key factors help explain the equity market’s advance:
- Part of the answer is that investors were not paid in 2011. The S&P 500 Index produced barely positive returns last year despite very robust earnings growth of 15% to 20%.
- The housing market has improved dramatically, albeit off a very low base. Housing inventory from foreclosures and short sales has been sharply reduced, and prices have increased year over year in many markets. After a disastrous five to six years, public homebuilders are seeing a surge in deliveries, traffic patterns, and order backlog. The impact of stronger housing prices on consumer behavior and psyche should not be underestimated. Consumer net wealth and confidence are greatly influenced by housing prices, and this situation has clearly improved over the last nine months.
- Corporate profitability has held up fairly well despite the slowing economic environment. In fact, for the most part, corporations continue to pile up more cash on their balance sheets even with significant dividend increases and/or stock buyback programs.
- Investor sentiment towards equities remains poor as evidenced by continued outflows from equity mutual funds. While this is often a contrary indicator, stocks are still attractively valued on a long-term basis and particularly cheap relative to bonds.
- Central bankers at the Fed, European Central Bank, and People’s Bank of China are backstopping sovereign debt credit markets and limiting tail risk in the global markets.
Once the U.S. election is over and many of the existing uncertainties are resolved, we believe that economic growth will be able to muddle through the next six to nine months. In the meantime, an emphasis on high quality stock selection remains increasingly important.
Read Kayne Anderson Rudnick’s third quarter market review.