Records Come … Then Go as Stocks End Lower
U.S. equities got off to a strong start last week, with the S&P 500 hitting a new high and the Nasdaq Composite Index crossing the 5,000 threshold for the first time in 15 years. However, the euphoria did not last and stocks eventually fell toa three-week low. For the week, the Dow Jones Industrial Average fell 1.52% to 17,856, the S&P 500 Index dropped 1.57% to 2,071, and the Nasdaq lost 0.72% to close at 4,927. Meanwhile, the yield on the 10-year Treasury rose from 2.00% to 2.25% as its price correspondingly fell.
With the Nasdaq reaching a milestone not seen since the dot-com boom and the broader equity bull market entering its seventh year, many investors are once again anxious that stocks are in a bubble. To us, the greater near-term danger may be somewhat more prosaic: a more aggressive Federal Reserve (Fed).
We’re Not in 2000 Anymore (Thankfully)
With the current bull market now one of the longest ever and the Nasdaq backat a level synonymous with the excesses of the tech bubble, is it time to get out of stocks? For long-term investors, we believe the answer is no.
While the bull market has indeed been long-lived, there is an enormous difference between the stock market today and 15 years ago. Back at the peak in 2000, the S&P 500 Index traded at roughly 30 times trailing earnings, while the Nasdaq was fetching a sobering 175 times trailing earnings. Today, those figures are 18.5 and 31, respectively. That’s not cheap, but certainly much less extreme.
In addition, the yield on the 10-year Treasury note was over 6% 15 years ago versus roughly 2% today. This indicates that the risk premium of stocks versus bonds (that is, the excess return stocks offer over Treasuries) is much higher today than it was then. In other words, valuations are more attractive on a relative basis. Outside the United States, stock prices look even more reasonable. The MSCIAll-Country World Index ex-U.S. is trading at roughly 16 times trailing earnings, comfortably below the long-term average.
Of course, none of this is to say a bear market can’t occur. Both secular growth plays, such as social media, and slow-growing dividend payers, like utilities and real estate investment trusts (REITs), are extremely expensive. But overall, a healthy earnings environment has kept valuations from approaching the levels that marked the peak back in 2000.
Fed Poised to Hike Rates
We remain comfortable with stocks over the long term, but acknowledge that the U.S. market may be vulnerable in the near term. We saw this last week, when U.S. stocks lost ground as Europe and Japan continued to advance. Indeed, Friday’s 1.4% sell-off in the U.S. was the worst since Jan. 5.
Until recently, benign comments from Fed officials have soothed investors. However, Friday’s unexpectedly strong non-farm payroll report reminded investors that 2015 is likely to bring the beginning of a tightening cycle, the first in almost a decade.
February’s jobs report confirmed the strength in the U.S. labor market. New jobs numbered 295,000, well above expectations, with the gains particularly evident incyclical sectors. Over the past seven months, the U.S. has created two million net new jobs. While job creation is running at its best levels since the late 1990s, structural issues persist and both labor force participation and hourly earnings fell last month.
All told, however, the employment picture is predominantly strong—strong enough to suggest a growing likelihood that the Fed will hike interest rates in June or September. The prospect for an earlier than expected hike pushed rates higher on Friday. The two-year Treasury yield broke above 0.70% while the 10-year yield climbed above 2.25% for the first time since late December. Other rate-sensitive assets sold off as well: Utilities are now down 13% from their January high and gold, which was down more than $30 on Friday, traded below $1,200/ounce for the first time since early January.
The rotation out of defensive names into more cyclical companies is evident in recent fund flows. Last week, investors added $2.3 billion to consumer cyclical exchange traded funds (ETFs) while taking $1.6 billion out of utility ETFs. We expect this rotation to persist and continue to advocate that investors underweight bond market proxies, like utilities, instead favoring cyclical growth companies, which should benefit from a stronger economy.
