Thursday, April 17, 2014

4 reasons the first quarter was better than it appeared

By Tim Clift

Opinion: High-flying stocks fell to more reasonable levels

Half full, not half empty: Equities may not have gained much so far this year, but there were important changes in the market.

After the S&P 500 Index ended last year at an all-time high (with a 10.5% gain in the fourth quarter alone), optimism and momentum were strong leading into 2014. But something changed all of a sudden.

Instead of extending its advance, the benchmark index eked out an increase of only 1.80% during the first quarter. (The bond market, as measured by the Barclays Capital Aggregate Index, climbed 1.84%.) And the S&P 500 fell as much as 4% in the current quarter.

What’s worse, the stock market was driven in the first quarter primarily by “boring” stocks like utilities and “old technology” companies including Microsoft /quotes/zigman/20493/delayed/quotes/nls/msft MSFT -0.47% . Darlings such as Amazon.com /quotes/zigman/63011/delayed/quotes/nls/amzn AMZN -0.53% , Facebook /quotes/zigman/9962609/delayed/quotes/nls/fb FB -0.57%  and Gilead Sciences /quotes/zigman/72849/delayed/quotes/nls/gild GILD +0.46% fell, and the magnitude of the reversal was breathtaking.

For example, biotechnology and social-media stocks, the two best-performing groups in 2013, suffered a significant drop after a positive start in 2014. The iShares Nasdaq Biotechnology ETF /quotes/zigman/85342/delayed/quotes/nls/ibb IBB -0.46% ended the first quarter with a 16% drop from its high during the period, as did Facebook, the largest of the social-media stocks.

On the macroeconomic front, it didn’t look much better. Largely due to severe weather, first-quarter gross domestic product (GDP) growth is expected to slow to less than 1% when the government releases its results, compared with 2.6% in the fourth quarter.

As the great economist Paul Samuelson said: “The stock market has predicted nine of the last five recessions.” One little-changed quarter is hardly the end of the world. In fact, once you look beyond the headline numbers, we believe that you’ll find positive developments that are constructive for a sustained, secular bull market. Here are the top four reasons why the first quarter was, to us, healthy for stocks. And how that could lead to another bull market this year.

1. The correction in momentum stocks removed a lot of “froth”

It is important to understand that today’s high price-to-earnings momentum stocks, such as Amazon.com and Facebook , are not the same as many of the dot-com high-fliers of the tech bubble. Today’s tech stars tend to have real businesses, revenues and earnings, and some of them are mega-caps with market capitalizations above $50 billion. A couple of them even exceed $100 billion. These stocks do matter to the stock market. For example, the biotechnology group makes up nearly 25% of the health-care sector, which is the third-largest economic industry in the S&P 500.

The decline of these high-fliers, which brought their price-earnings multiples to more “normal” levels, was effective in lowering the valuation of the broader market. But the big drops were generally limited to these stratospherically priced shares, not the market overall.

In addition, the money that left these high P/E shares did not appear to leave the stock market — it simply moved to those with more reasonable valuations: the “boring” stocks. That’s why, despite the severe sell-off of high P/E momentum stocks, the overall market barely budged. This market leadership rotation from high-P/E stocks to low-P/E shares is a timely and healthy development, as the primary concern of most investors has shifted from the health of the economy to the fundamental valuation of stocks.

2. Interest rates are falling

The only things that are certain in life are death and taxes, and now we can add rising interest rates. Or not. Although the much-dreaded quantitative-easing tapering has begun, interest rates actually trended lower during the first quarter. That’s right — interest rates fell. Ten-year and 30-year Treasury yields, the long-term interest rates most critical to mortgage rates (and thus the housing market), tumbled 31 basis points to 2.7% and 41 basis points to 3.56%, respectively. As for the 5-year and 7-year Treasury yields, the interest rates most critical to consumer loans such as car loans, they too ended the quarter lower than they started. Lower borrowing rates can help stimulate more consumer purchases, feeding economic growth and providing a catalyst for higher stock prices.

3. The euro zone is recovering

While Russia and Ukraine dominated the headlines, the euro zone economy continued its recovery. European stock markets actually outperformed the U.S., especially the much-loathed peripheral countries affectionately named “PIIGS” (Portugal, Italy, Ireland, Greece and Spain). The stock markets of the two biggest peripheral countries, Italy and Spain, gained 14% and 5%, respectively. Even Greece, the poster child of the European sovereign debt crisis, registered a double-digit increase.

4. Healthy skepticism

“Flash Boys,” Michael Lewis’ new book, asserts that the high-frequency-trading market (HFT) is “rigged.” Although Lewis applied that damning word to a small part of the stock market that affects only a few market participants, such as program traders and penny-stock day traders, it has caused a major kerfuffle across Main Street and Wall Street. The popularity of the book confirms that most investors are not jubilant and blinded by market gains, and in fact retain a healthy level of skepticism. That is healthy, and far from the euphoria that’s a hallmark for stock market tops.

As wonderful as big stock market gains may feel, investors need to bear in mind that back-to-back double-digit quarterly gains and 30%-plus annual gains are rare. They may even be unhealthy. Typically, after a period of strong gains, the stock market needs a breather. The rotation from high-fliers to underperformers is necessary for the stability of the overall market. Profit-taking and a fresh look at stock valuations are signs of a robust market taking a rest.

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