ITS ALL ABOUT THE FED (Again)

This quarter’s newsletter will focus exclusively on the US markets. The European and foreign markets have remained relatively stable. The key influence on the US markets are the recent statements by Federal Reserve Board Chairman Bernanke. His remarks, which are typically cryptic, leads to a positive “read” on the US economy.

The financial markets saw a marked increase in volatility during the recently completed fiscal quarter. The quarter began on a strong note with a strong upward trend. Mid-quarter comments from The Federal Reserve Board (the Fed) Chairman Bernanke concerning a sooner than expected end to the Fed’s easy money policies resulted in a sell off in all asset classes. Both stock and bond markets posted significant declines in a relatively short period of time as investors adjusted to the prospect of higher interest rates. The US stock market (as measured by the S&P 500) gained 2.4% during the quarter, while the Canadian Market (as measured by S&P/TSX 300) declined 4.9%. Exposure to resource and gold stocks weighed heavily on the Canadian market. The Canadian bond market declined 2.4% as yields on the benchmark five year bond increased from 1.2% to 1.8%.

Chairman Bernanke’s comments signalled conditions for a change in monetary policy. He reiterated that the Fed would not remove the excess liquidity previously injected into the financial system thus avoiding the risk of creating a tighter credit environment. The Fed has no interest in contracting credit conditions and potentially choking off the fragile economic recovery. The Fed would initially reduce bond purchases prior to commencing a money tightening policy. A 1% rise in interest rates from current historically low interest rates, would be unlikely to hinder economic growth.

Any discussion of an impending transition from an “easy money environment” of low interest rates to a more neutral policy will result in heightened investor anxiety. We believe that the Fed's exiting its ultra low interest rate policy should be viewed as positive. It reflects the anticipation by the Fed of a sustainable, improving US economy. Make no mistake about it, the US recovery is happening. US Auto sales growth remains healthy while housing activity is red hot. The excess supply of housing inventory of two years ago has reversed and there is now an under supply of homes for sale. The result is new home starts reaching post-recession highs and rising home prices. These positive trends have translated into improved employment data.

Over the last couple of years, we have witnessed low interest rates driving stock market gains. This is not sustainable over the long term. A strong, growing economy fuelling growing corporate earnings is needed to support rising stock prices over a longer period of time. The fundamental underpinnings are in place to enable a healthy stock market over the next couple of years. The stock market will not rise in a straight line without corrections. Volatile stock markets have typically been the norm, unlike the relatively calm markets of the last nine months. The stock market is in a choppy consolidation phase, which is likely to persist through the summer. Stock price fluctuations are currently reflecting the tug of war between an improving economy and the prospect of rising interest rates.

We believe that the Fed has the best view of the economy. When investors come around to the concept that rising interest rates is a positive read for economic and corporate outlooks, the stock market will resume its upward trajectory. With the recent bond market decline, we continue to believe that bonds are not a profitable near-term investment. Our concern remains that a stronger economy will result in higher interest rates, even if the majority of the near-term increase has already occurred. From a historical perspective, a move from 1.6% to 2.5% for the US ten year bonds is a big move. While 2.5% is still considered low, it does not provide enough of a cushion to reflect the risk of another big rate increase sometime over the next year.

Our bullish view of the stock market has been based on attractive stock valuations. After the sizable US stock market gains over the last year, it is increasingly difficult to call the market cheap. The US stock market currently trades at 16 times trailing earnings, which is more in line with its historical fair value. As such, we would characterize the stock market as reasonably valued. We prefer not to assume that valuations will rise in excess of fair value when analyzing future market trends. We maintain this conservative approach in order to more realistically determine asset allocations. Future stock price gains are likely to come from earnings growth than from increased valuations. Applying a 16 multiple on 2013 S&P 500 estimates ($108), yields a target of 1730 by the end of this year. This results in a potential 8% return by year end.

Since the recession of 2008-2009, investors have flocked to bonds due to their perceived safety and income orientation. Chart 1 highlights that only in the last year have investors begun to put money back into the stocks. Equity markets inflows have been inconsistent and still represent only a fraction of the money that has poured into bond funds over the last four years. As a significant amount of money remains sitting in cash accounts or bonds, stock market inflows could persist for a number of years. The great rotation from bonds into stocks has barely begun.

Chart 1: Cumulative Fund Flows

Source: BMO Capital Markets Strategy Group


We remain positive on the US stock market due to an improving economy, increasing corporate earnings and relatively low interest rates. We believe that the US stock market offers the best potential risk adjusted returns. Valuations rising to something closer to fair value have made individual stock selection increasingly important in generating positive returns.