Robert C. Doll, CFA
Senior Portfolio Manager,
Chief Equity Strategist
Nuveen Asset Management, LLC

Weekly Investment Commentary

Equities Recover Some Ground and
Still May Have Room to Run


October 27, 2014
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Key Points

  • The equity market rally reversed a significant portion of the damage caused by the recent correction
  • Despite some fears to the contrary, we do not believe recession or deflation risks will materialize in the United States.
  • We think this bull market remains intact, meaning equities have not yet reached cyclical highs.


With global deflation and growth fears fading, U.S. equities snapped their four-week losing streak last week with the S&P 500 Index gaining 4.1%.1 This advance marked the largest weekly gain since January 2013.1 Following the correction from the mid-September to mid-October, the S&P 500 has now rallied 8%, leaving it only 3% from its all-time high.1

 

The U.S. Economy Remains Fundamentally Sound

Volatility has climbed over the past several weeks as investors have become uneasy about the state of the global economy. However, we do not believe we are seeing any sort of large-scale systemic risks in the global financial system such as what occurred in 2008 or 2011. Rather, we think the economic risks are mostly isolated to Europe and some emerging market economies.

Although there are concerns to the contrary, the U.S. economy remains in acceleration mode, and we think there is little chance that we’ll see either a recession or a deflation scare in the United States. Investors are coping with new issues that are prompting higher levels of volatility (such as Ebola and heightened geopolitical risks) but the state of the U.S. economy remains solid.

 

Weekly Top Themes

  1. Corporate earnings are beating expectations. With over half of the companies in the S&P 500 reporting third-quarter results, earnings have been 4% better than expected, while revenues have surpassed expectations by 1%.2 We anticipate overall earnings-per-share ratios to wind up at 10% for this quarter versus expectations of 8%.2
  2. Wages should rise, suggesting deflation is not a serious risk for the United States. Unemployment is falling and business leaders have been claiming that there is a shortage of skilled labor in the U.S. Together, these factors should translate into upward pressure on wages.
  3. We expect higher levels of spending from the federal government in the coming years. Regardless of who wins the next presidential election, the sequester is unlikely to hold past 2016. Republicans are eager to spend more on defense, while Democrats would like to see additional spending on infrastructure and other domestic programs. Such spending would probably be offset by entitlement reform and/or tax increases.
  4. The Chinese economy is likely to continue to struggle. Chinese policymakers are attempting to strike a delicate balance between maintaining growth and pursuing structural reforms. While not an impossible task, it will be difficult to rein in the country’s credit excesses without undermining growth.
 

Equities Have Not Reached the Top of This Bull Market

Equity markets have clawed back much of the losses they endured during the recent correction. While stocks are likely to remain volatile, we believe the recent weakness is not the start of a bear market but rather little more than a mid-cycle correction. While parts of the world are troubled (we would highlight Europe, where growth is quite weak) the United States remains solid thanks in part to an improving labor market, lower interest rates and falling energy prices. Additionally, improving corporate profit trends are a positive for the U.S. and should boost equity prices.

Sir John Templeton famously stated that “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” The evidence we see suggests we are still far away from the “euphoria” phase that normally accompanies the top of a bull market. The U.S. financial system and housing market are healing, corporations are highly profitable and monetary policy remains accommodative. Additionally, the recent drop in oil prices and the longer-term decline in unemployment should help consumer spending. And with inflation not a near-term concern, the Federal Reserve has the flexibility it needs to proceed cautiously in tightening policy.

Equity markets will likely face ongoing near-term volatility. And at the same time, investor anxiety over issues ranging from geopolitics, Ebola and global growth is not going away. Nevertheless, we remain convinced that the bull market remains intact and that U.S. equities look attractive.

 

1 Source: Morningstar Direct, as of 10/24/14
2 Source: FactSet and Bloomberg

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.



 

Last Week's Commentary

Equity Losses Continue, but This Correction May Be Ending


October 20, 2014
 
 

Key Points

  • Markets endured a sharp pullback and higher volatility, but technical factors suggest we may be nearing the end of the current correction.
  • Long-term, we believe fundamentals remain sound, the U.S. economy should continue to grow and equities should be able to grind higher.


U.S. equities endured a high degree of volatility last week, dropping sharply before recovering some of their losses. For the week, the S&P 500 Index lost 1.0%, marking the fourth consecutive down week for stocks.1 Global growth concerns and oversold conditions contributed to the downturn, as investors generally focused on large-scale macro issues and risks rather than on fundamentals and corporate earnings. Defensive sectors such as health care and consumer staples drove the market lower, while a bounce in cyclical stocks helped industrials and materials outperform.1 Small cap stocks rallied and outperformed large caps as they snapped a six-week losing streak.1

 

Market Technicals Turned Positive Amid High Volatility

Much of last week’s volatility occurred on Wednesday when equities opened by plummeting close to 2.5% amid huge volume.1 We estimate as much trading occurred in the opening half-hour as we see in a typical day. At the same time, the yield on the 10-year Treasury fell from 2.20% on Tuesday to 1.86% on Wednesday morning.1 Such moves represented panic selling in equities and panic buying in bonds as investors fled into “safe haven” assets.

Importantly, however, markets recovered some of their early-day losses before experiencing another pullback later Wednesday. Although the afternoon decline was greater than that morning’s, it was more orderly with less trading volume. This suggests we may have been seeing the beginning of the end of corrective action.

Thursday saw an additional test of the market lows, but investors began buying shares back, which was another good sign. More importantly, market factors showed at least some degree of risk appetite returning in the second half of the week. Cyclical sectors outperformed defensive sectors, energy stocks recovered, commodity prices rose and equities saw notable advances on Friday.1 We view all of these factors as further evidence that the correction may be in the process of ending.

 

We Believe This Equity Bull Market Should Persist

To put current market action into perspective, this is now the fourth correction we have seen so far this year. Equities fell 7% in January, 4% in April and 5% in August. If the bottom seen on Wednesday holds (1,820 for the S&P 500 Index) that would represent a 10% decline from the intraday high reached on September 19.1

Despite the most recent decline, however, we believe fundamentals have not changed significantly. The proximate cause for the current pullback appears to be heightened concerns about European growth and deflation, but these issues are not new. Likewise, concerns over Federal Reserve policy, geopolitics and corporate earnings have been present for months. In our view, the current correction has been more technical in nature. Markets were overdue for a 10% correction and investors seem to be responding to the same fears that have been around for some time.

We remain cautiously optimistic about the state of the U.S. economy. If anything, recent trends could help. Energy prices have fallen sharply over the past few weeks and months, which acts as a de-facto tax cut for consumers. And lower interest rates should help the housing market. As long as U.S. growth holds up, corporate earnings should be decent enough, allowing equity markets to grind higher.

In addition, equity markets tend to perform quite well in the aftermath of midterm elections (often following a difficult September/October period). In fact, since 1950, the S&P 500 Index experienced positive returns in every six-month period following the last 16 mid-term elections, with an average gain of 16%.2

At the end of the day, we still believe that equities appear attractive, especially relative to Treasuries. At present, the dividend yield of the S&P 500 Index is 2.1%, which is pretty close to the yield on the 10-year Treasury.1 This means that stocks are producing roughly the same current income as government bonds, but stocks also offer the prospects for growth and dividend increases, which bonds do not.

Looking ahead, we expect volatility to remain relatively high and markets could again test the bottoms seen last week. But evidence suggests it is more likely than not that this current correction is ending and that the long-term prospects for equities remain sound.

 

1 Source: Morningstar Direct, and Bloomberg as of 10/17/14
2 Source: BCA Research

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.




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A Word on Risk
The views and opinions expressed are for informational and educational purposes only as of the date of writing and may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-investment-grade bonds involve heightened credit risk, liquidity risk, and potential for default. Foreign investing involves additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. Past performance is no guarantee of future results. Certain information contained herein is based upon third-party sources, which we believe to be reliable, but is not guaranteed for accuracy or completeness.

Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc.

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