On the surface, the first quarter of 2014 appears to be decent. The S&P 500 eked out a gain of 1.8% in the first three months of the year, despite heightened geopolitical tensions, a changing of the guard at the Federal Reserve, and frigid weather hampering economic growth. Accounts managed by Oak Associates have topped the S&P 500 year-to-date. That being said, signs of internal weakness are present in US equities.
The best-performing sector year-to-date is the Utilities Sector up 10.8%, considered a Defensive group, while the Consumer Discretionary Sector, an economically cyclical sector, has fallen 2.8%. Towards the end ofthe quarter, stocks with high growth rates and price momentum also suffered sharp corrections. Large-cap stocks are also outperforming higher risk, small-cap companies. These observations suggest an aversion to risk and more cautious stance by investors. We cannot predict whether a prolonged correction will develop, yet given the 32% gain achieved in 2013, a moderate consolidation/pull-back might actually be a healthy occurrence. The market might just need a time out.
The stock market has an excellent ability to overlook noise and focus on the fundamentals. This ability is by no means flawless nor precise, but stocks routinely see beyond the stories dominating CNN or CNBC and remain focused on economic outlook. Russia’s annex of the Ukraine’s Crimean Peninsula is yet another example of a major media event that failed to garner much attention by market averages. Indeed, from the time when the protests in Kiev turned into a revolution (February 19, 2014), to the eventual de facto annexation of Crimea (March 18, 2014), the S&P 500 rose 2.6%.
Geopolitical issues, if they lead to a disruption in commerce, are a long-term concern, but they are also a distant second to the underlying health of the domestic economy. Russia clearly saw an opportunity to regain control of a region that is of vital strategic value to the Russian Navy. President Putin must have concluded that the image of a modern Russia carefully crafted by the Sochi Olympic Games was worth sacrificing for its long-term military goals. The fact that Russia is an 800-pound gorilla is no surprise to neighbors or regional natural gas importers. President Putin, however, is unlikely to heed any disciplinary action from world leaders and retreat to his own naughty chair.
Closer to the heart of US equities are the policies and actions of the Federal Reserve. Any change in monetary policy could have dramatic effects on liquidity, interest rates, and financing costs. Even though it is early in Chairman Yellen’s reign at the Fed, the message from the board of influential policy makers continues to imply low interest rates, a hesitant withdrawal from quantitative easing, and willingness to address structural unemployment issues as needed. This stance has been endorsed by the stock market for over 9 months and ever since the concept of tapering was introduced. Higher interest rates are something to heed, but the unintended consequences of keeping interest rates artificially low are not without risk either. The Fed is aware of this and yet needs to remain accommodative to the housing sector and job creation given the stagnant labor markets. Debate over when interest rates will creep higher persists, but a normalization of rates is likely to correspond to clear economic strength. Predicting the end of a bull market is not something many do well, and the gains achieved between now and then can be tremendous. We therefore remain fully invested.
The mixed performance seen in the stock market in Q1 likely reflects the additional uncertainty forthcoming in economic data. A terrible winter for much of the United States has affected retail sales, limited construction starts and slowed home buying turnover. This creates a situation where year-over-year changes and subpar growth rates get discounted. Is the economy weakening, or did the brutal winter simply delay economic activity? Is consumer confidence plummeting, or are spending habits simply being disrupted short-term? This distinction will be important.
In conclusion, the outlook for US equities hasn’t changed much over the last three months. The economic recovery continues with not-too-hot, not-too-cold results. The housing recovery has slowed with higher mortgage rates, but affordability remains supportive and higher home prices boost consumer confidence. The Federal Reserve plans to remove the punch bowl of loose monetary policy as soon as prudent, but the end to quantitative easing is still a ways off. And Russia is a bully. None of this is new news. Our outlook for US stocks remains positive. The structural slack in the economy and softness in emerging markets should keep inflation at bay. A low inflation, modest growth environment tends to be very supportive of higher stock prices. Fundamentals, profitability, and capital discipline all remain favorable. Even as interest rates move higher, it should take several quarters before it stifles the environment for stocks.
Best regards,
Robert Stimpson, CFA
Portfolio Manager
Oak Associates, ltd.
3875 Embassy Parkway| Suite 250|Akron, Ohio 44333|Main 330-668-1234| www.oakassociates.com
