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

Weekly Investment Commentary

Geopolitics Spark Volatility, but Earnings Should Help Equities


July 21, 2014
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Last week’s market action was notable because of the pickup in volatility. Stocks fell sharply on Thursday following the downing of the Malaysia Airlines flight in eastern Ukraine, but bounced back on Friday. In addition, rising tensions in the Middle East acted as a drag on risk asset prices. In contrast, solid earnings results and a continued advance in merger and acquisition activity acted as tailwinds. In the end, the positive factors won out, with the S&P 500 Index posting a 0.6% gain for the week.1

 

Three Scenarios: Where Are Markets Headed?

Equity market valuations have been rising over the past few years, and since higher valuations are associated with lower long-term returns, it is fair to wonder where stock prices may be heading from here. We would forecast three scenarios, from most to least likely:

1) Earnings accelerate, and equities grow into their higher valuations.

2) We witness uneven economic and earnings growth, which slows the Fed normalization process, and markets grind higher.

3) A significant market pullback occurs, caused by sharply rising bond yields or substantial earnings disappointments.

 

Weekly Top Themes

  1. The situation in Ukraine could cause additional volatility. The airline downing occurred just hours after new sanctions from the U.S. and European Union against Russia were announced, resulting in a significant increase in tensions. These events will likely continue to result in escalating market volatility.
  2. Corporate earnings should accelerate. After growing 5% in the first quarter, expectations for second quarter earnings growth are around 6%.2 We think these expectations are too soft for a couple of reasons. First, actual earnings have historically beaten expectations by about 3%.2 Second, expectations for the financial sector are quite weak and may be dragging down forecasts for the rest of the market. We expect double-digit nonfinancial earnings growth for the second quarter and also believe results will continue to be strong in the following quarters.
  3. Falling oil prices are a boon for equity markets. It now appears that the recent spike in oil prices was a temporary event caused by the turmoil in Iraq. In our view, unless we see a significant acceleration in Chinese economic growth, oil prices should remain relatively well-contained (although temporary price spikes could occur again). Steadier oil prices would be a positive for global economic growth and equity markets.
  4. Tax reform for overseas earnings is unlikely. Absent broad corporate tax reform (which does not appear likely), we do not expect to see any sort of repatriation holiday or other reforms that would lower tax levels on non-U.S. earnings.
  5. A major equity market retrenchment looks unlikely. Since the 1970s, every major market correction has been preceded by a Fed rate hike, a double-digit rise in oil prices or an intense global crisis.3 We think the lack of these catalysts puts the odds of a major pullback quite low.
 

Cyclical Sectors Continue to Look Attractive

U.S. economic growth appears to be accelerating, which should be conducive to continued advances in equity prices. Valuations have been moving higher, and markets could be susceptible to a correction, but we believe any such setback should be modest and temporary, particularly considering that central bank policies are still accommodative. Additionally, we expect corporate earnings trends will improve along with the economy, which should act as a positive catalyst for the markets.

With this backdrop, we continue to support a pro-cyclical investment stance. In particular, the technology and industrials sectors appear to have strong earnings growth prospects and should benefit from an increase in capital expenditures, which should occur as the economy picks up steam.

 

1 Source: Morningstar Direct, as of 7/18/14 .
2 Source: RBC Capital Markets.
3 Source: Cornerstone Macro.

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

Economic Signals Are Improving, Which Should Help Equity Prices


July 14, 2014
 

U.S. equities lost ground last week, with the S&P 500 Index dropping just under 1%, its largest weekly loss since early April.1 Cyclical sectors lagged, while defensive areas (chiefly utilities and telecommunications) led the way.1 A number of factors could be blamed for the decline, including signs of slowing European growth and lingering debt problems, as well as some downward revisions in corporate earnings guidance. In our view, however, the most reasonable explanation for the pullback may simply be fatigue and consolidation following the multi-week price advance. In any case, this sort of pullback is a normal part of a bull market. Overall, our observations point to stronger economic growth and higher equity prices, and we would offer seven reasons why we remain constructive:

 

Seven Reasons to Remain Positive

  1. Leading indicators are pointing to an economic acceleration. The Purchasing Managers Index readings have been moving higher,2 payrolls are increasing,3 inflation expectations are rising, bank lending levels have accelerated and earnings estimates are generally improving.
  2. The U.S. manufacturing and energy renaissance is continuing to unfold, with manufacturing employment increasing at its fastest pace in over 30 years,4 and U.S. oil production surging as imports from OPEC decline.5
  3. It has become increasingly difficult for those with bearish views to find indicators that don’t show an acceleration in growth. We expect yields to rise as bond markets begin to realize that the recovery is more certain.
  4. The current recovery is the slowest in the post World War II period.6 As a result, the economy still has excess capacity, which should allow growth to continue.
  5. Monetary policy should remain accommodative for a protracted period, although the Federal Reserve will increase the fed funds rate at some point.
  6. Historically, bull markets falter when recessions ensue, not when valuations become more expensive. And we believe recession risks are very low.
  7. In our view, the main driver of the bull market has shifted from supportive Fed policy to fundamental factors. A continued focus on earnings growth, dividend increases, valuations and other fundamentals should keep the market grounded and prevent it from getting ahead of itself. Although some investors believe the market has already gone too far and is overvalued, we find this sort of controversy reassuring. It is when investors start ignoring fundamentals altogether that markets tend to enter into bubble territory.
 

An Overweight to Equities Still Makes Sense, but Watch for a Market Correction

Investor anxiety appears to be high, but the bottom line is the economic backdrop and market fundamentals sill warrant overweight positions in equities. As the global economy slowly improves, U.S. corporations become more healthy, consumers reduce debt levels and monetary policy stays supportive, we believe equity markets look attractive. Additionally, “risk free” Treasury bonds and cash are overvalued or are producing extremely low returns. Finally, we would point out that many investors are still cautiously positioned and ample cash is sitting on the sidelines, indicating equities should have further room to run.

This is not to say that risks have vanished, however. Given the fact that markets appear fatigued and that it has been nearly three years since we have seen a 10% correction,1 we could see a pullback occur at any time.

We are often asked what could cause such a correction. A few likely culprits could be a jump in bond yields, a spike in oil prices or heightened concerns about Fed tightening. When and if a correction does happen, we would expect it to be a temporary occurrence as long as the economy remains on track. For now, and over the next six to twelve months, we expect economic growth to improve, providing a tailwind for corporate earnings. With such a backdrop, we expect stock prices to rise and bond yields to move higher.

 

1 Source: Morningstar Direct, as of 7/11/14.
2 Source:Institute of Supply Management.
3 Source: Bureau of Labor Statistics.
4 Source: Cornerstone Macro Research.
5 Source: U.S. Energy Information Administration.
6 Source: Bureau of Economic Analysis.

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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