Russell Investments global head of investment strategy Andrew Pease is worried that investors are becoming overly optimistic as the S&P 500 index reaches the firm’s target price for the year of 1,500 and has given four reasons why this might reverse.
He writes “Our bottom line is that we think equity markets are fully valued and a lot of the upside risks have now been priced in. Markets move in cycles and there are enough warning signs to suggest investors are becoming overly optimistic. Longer-term, we expect equities to outperform bonds, but for now we are cautious about chasing the current rally. We want to avoid the traps of buying and selling on market sentiment in an ongoing risk-on/risk-off environment.”
The firm has given its five reasons explaining why the market has run so hard, and four things that could cause a reversal which we have listed below. This is the link to the full conversation blog.
Why has the market run so hard?
- The U.S. avoided the “fiscal cliff” and there is confidence that the deadlines for the debt ceiling and sequestered spending cuts will also be successfully negotiated.
- The news on the U.S economy has been positive. The housing market is continuing to recover and labor market indicators, such as weekly jobless claims, are improving.
- There has been better (or at least less bad) news from Europe. Bond yields have fallen to safe levels for Spain and Italy and a near-term crisis looks less likely.
- China is recovering. The manufacturing Purchasing Managers Index (PMI) is at the highest level in two years and most forecasters believe that a moderate recovery is underway.
- The fourth quarter U.S. corporate profits reporting season has so far been slightly better than expected.
What could cause a reversal?
- Failure to prevent large automatic government spending cuts. A deal was made to moderate the automatic tax increases in the U.S. at the beginning of the year and the debt ceiling deadline has been postponed to May 19. The main outstanding issue is the $110 billion (0.7 per cent of U.S. GDP) of automatic spending cuts that were agreed to at the time of the debt ceiling debate in August 2011. These take effect on March 1, and although the recent tax deal delivered around 1.5 per cent of GDP worth of fiscal tightening, adding on the full automatic spending cuts will take this year’s fiscal tightening to more than 2 per cent of GDP. That’s enough to undermine the current confidence in the U.S. growth outlook. Even though investors have become used to politicians doing last minute deals and are complacent about the risks of a stand-off, the spending cut debate could be enough to unnerve markets and deliver a setback for U.S. growth expectations.
- More problems in Europe. Mario Draghi’s success in reducing bond yields across the euro zone has created a perception that the crisis is over. But this view is likely to be tested in coming months as economic data disappoints and sustained high unemployment creates social and political tensions. Fiscal austerity is ongoing and the European Central Bank seems unlikely to ease monetary policy further and euro strength is undermining export competitiveness. Although more positive of late, recent economic data releases point to ongoing recession and the Italian elections in late February will refocus attention on the euro-zone’s core problems.
- Earnings disappointments. The fourth quarter reporting season has started optimistically but the outlook for 2013 is at best lacklustre. U.S. corporate profit margins are high and forward indicators such as Chief Executive Officer confidence point to weak growth. Meanwhile the bottom-up consensus expects close to 10 per cent Earnings Per Share growth for the S&P 500® Index companies this year. Russell believes that overall profit growth of 5% would be a good outcome given that nominal GDP is unlikely to expand by much more than 4 per cent.
- Over-optimism and complacency. Citigroup’s economic data surprise index, which measures how economic data matches consensus forecasts, has turned negative signalling that data releases are now failing to match more optimistic forecasts. The VIX index is at a five and a half year low below 13. Investors may be seeing few near-term risks and are becoming over confident about the economic outlook — a worrying combination.