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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
Michelle Gibley CFA, Director of International Research, Schwab Center for Financial Research
Key Points
Despite an earnings season that has been much better than expected so far, investors appear to be again focusing on more macro concerns. Europe and China are dominant concerns but US growth sustainability is also being questioned. We remain optimistic on the ultimate direction of the stock market. The Fed meeting provided no changes but did show a slightly more hawkish tilt in their economic forecasts. Meanwhile, the US government continues to play a dangerous game of chicken as election season is already in high gear and the so-called "fiscal cliff" looms. Confidence is again waning regarding the ability of Europe to make the reforms needed to solve its debt crises, many of which we believe are structural in nature. But despite fears of a hard landing in China, growth continues and stocks have outperformed.
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.
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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 samethe 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.
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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. Housing has very likely been affected by the weather. We believe the housing market continues to show improvement but were disappointed by the recent data releases that showed existing home sales fell by 2.6% and housing starts dropped by 5.8%. However, the forward looking building permits number rose 4.5%boding well for future activity. And, even within the disappointment there were glimmers of positive news as the drop in starts was almost entirely attributable to the volatile multifamily component falling 16.9%. Finally, inventories continued to declineexisting homes on the market are down 22% relative to a year ago. The Index of Leading Economic Indicators (LEI) rose for the sixth straight month, although upcoming seasonal adjustments suggest an upcoming weaker report. And, one odd note on the auto sector. Weve noted the sharp rebound in auto sales and the resulting contribution to economic growth, but that could be in near-term jeopardy due to a potential shortage of a resin known as nylon-12 used in brake and fuel systems. The potential shortage comes as a result of a chemical plant explosion in Germany that is expected to take production offline for at least three months. Auto executives have expressed serious concern.
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The Spanish government's credibility has been called into question because it missed its 2011 fiscal deficit target by over 40%, with the deficit registering 8.5% instead of the 6.0% target. This increases doubts about the ability to slash the deficit in 2012 and 2013, not to mention what appear to be overly optimistic assumptions in the deficit reduction plans in our opinion. We dont believe the situation in Spain necessitates an imminent bailout, but markets are nervous that the situation could deteriorate, necessitating a bailout over the next couple years. The ECB's three-year loans, also known as their long-term refinancing operations (LTROs), reduced the threat of a global banking crisis in our view. While the money was partly credited with yields plunging on debt of weak countries, the effect on government yields is fading. It may sound like a bit of a shell game, but after posting peripheral debt as collateral with the ECB to receive money, some banks in the periphery used the LTRO money to buy more debt of their home countries. This negatively increased the ties between weak banks and weak governments. Now, the ability to use LTRO money is running out due to banks capital rules. As such, the ability for Spanish banks, for example, to support Spanish government bond auctions, is waning. New bond issuance is increasingly dependent on foreign investors, at a time when foreign investors are increasingly shunning exposure to peripheral countries. The move in France and elsewhere toward policies that are unfriendly to businesses (banks and energy companies in particular), reject austerity, increase taxes on the wealthy and toward protectionism, are the wrong prescriptions in our view. Additionally, the socialist way of life may need to be re-examined, because many governments need to reduce spending. Healthcare and pension programs take up a large share of spending, which is likely to increase as populations are aging. Tax rates are already high in many countries, but better collection and reduced complexity of tax laws could likely bring in more revenues. The way out of the austerity trap, where weakening economic growth contributes to missed fiscal deficit reduction targets and new rounds of austerity, is growth. More concrete and aggressive policies need to be made to: increase flexibility of labor markets, and reduce restrictions on the ease of doing business. Structural reforms will take time to reap rewards; however, we dont see a magic cure in the short-term for the eurozones ailments.
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We believe the source of the recent downturn partly emanates from a further tightening of bank lending and we believe European banks, Spanish in particular, need additional capital.
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Source: FactSet, Global Insight. As of Apr. 24, 2012. 1 quarter moving avg.
While second quarter economic growth could be weak again and hard landing fears are not likely to dissipate soon, sentiment is overly negative in our opinion. It is interesting to note that despite the rampant fears, the Shanghai Composite Index has outperformed over the past month. Read more international research at www.schwab.com/oninternational.
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