Economic Update: August 2013

Stocks had another strong month in July with the large-cap S&P 500 index up 5.0% and the small-cap Russell 2000 up 7.0%. International stocks in developed markets were also 5.2% higher as measured by the MSCI EAFE index while emerging market stocks were up less than 1%. Bond prices stabilized during the month resulting in only a slight 0.1% gain.

At the end of June, Fed Chairman Ben Bernanke’s comments regarding tapering QE had spooked stocks and bonds alike. During July, his comments reassured investors that tapering was still a ways off as the economy is not yet on firm footing. Initial estimates for second quarter US GDP growth are 1.7%; however, these will be revised several times before they are final. First quarter GDP growth was originally estimated at 2.5% but after revisions, the figure dropped to a mere 1.1%. Many analysts expect the second half of the year to have stronger economic growth as the labor market, consumer spending, housing and autos have already started to show strength. Strategists at Federated Funds are expecting solid retail seasons for back-to-school and Christmas shoppers and believe an inventory restocking cycle will be starting up. Current consensus estimates for third and fourth quarter GDP growth are 2.3% and 2.7%.

Second quarter earnings reports have been mostly positive so far and show that nearly 3 out of 4 companies have beaten the analyst earnings forecast. That percentage is in line with the 4 year average. However, the news is not as positive when looking deeper at the numbers. Companies are not exceeding estimates by as much as they have averaged in the past – they have surprised to the upside by 3.2% but the 4 year average is a 7% surprise. In addition, some of the companies that beat estimates had previously revised their estimates lower. The earnings growth rate for the quarter of the companies that have reported so far is 1.8% (when financials are excluded it is -2.9%). If this is the final growth rate for the quarter, it will be the third-lowest quarter for earnings growth over the last 4 years.

Employment reports show similar concerns. The declining unemployment rate portrays that the economy is getting better. However, more than 2/3 of the jobs that have been created this year are part-time jobs while full-time positions have been eliminated thus resulting in more people being underemployed. Less people may be unemployed but more people are working part-time jobs than ever before.

Since US stock prices have increased nearly 20% year-to-date and earnings growth has only been 3.3% in the first quarter and 1.8% so far in the second, price earnings multiples have continued to expand. The current P/E multiple on the S&P 500 is 14.4 which is higher than its 3 and 5 year averages of 12.6 and 12.9 and roughly in line with the 10-year average of 14.1. Although stocks may not be considered over-valued at this level, they seem to be at least fairly valued. If earnings growth increases in the second half of the year along with the expected increase in economic growth, stocks may remain popular with investors – especially since the typical alternative is bonds.

The media’s attention to bonds has picked up and has focused on the negative returns bonds have had when yields increased. Articles have included colorful words and phrases such as “bloodletting”, “destroying savings”, “fallen off a cliff” and “harsh lessons” which has caused some bond investors to unnecessarily panic. True, when yields rose from 1.6% to 2.6% on the 10 year Treasury bond, returns fell 6% or more in some (not all) types of bond funds. However, when the yields were declining the previous year, bond funds had better returns due to appreciation. Plus, a repeat of a 1% yield increase in the next two months seems unlikely at this time. Therefore, recent bond performance does not mean that investors should shed bonds from their portfolios. Investors will likely be thankful they own some bonds if stocks become more volatile again (some analysts still expect a correction of 5% to 10%). Yields seem to have stabilized this month and as long as they don’t go up quickly, bond returns should not negatively affect total portfolio returns as they did last quarter.