More than $500 billion wiped off the value of U.S. stocks is providing opportunities for investors who remember that equities tend to rise when the Federal Reserve begins reducing efforts to stimulate the economy.
The Standard & Poor’s 500 Index, which has fallen 2.5 percent from its May 21 record, rallied an average 16 percent over two years the last four times the central bank started raising interest rates, according to data compiled by Bloomberg. While the 87 percent gain since December 2008 is the biggest following Fed reductions, the advance hasn’t pushed valuations above historical averages.
Bears say this time is different amid mounting pressure on the government to reduce spending and on the central bank to cut bond purchases that pump funds into the financial system even as the economy expands at the slowest rate following a recession since World War II. Bulls say a decision by the Fed to reduce stimulus would be proof the economy can expand on its own and that valuations are low enough to spur more share gains.
“The Fed tightening, that’s good for stocks,” John Canally, investment strategist at Boston-based LPL Financial Corp., which has $373 billion in advisory and brokerage assets, said in a June 12 phone interview. “You have to remember why they’re doing this, because they think the economy is in a self-sustaining phase, which ultimately is good for profits, which is good for stocks.”
Stocks fell for the third time in four weeks, with the S&P 500 losing 1 percent to 1,626.73, after Chinese industrial production rose less than forecast and investors awaited a meeting of the Federal Open Market Committee starting tomorrow. The retreat cut 2013’s gain to 14 percent and the increase since shares bottomed in March 2009 to 140 percent. The S&P 500 rose 0.8 percent to 1,639.04 at 4 p.m. New York time today.
Swings in prices have jumped since May 22, when Fed Chairman Ben S. Bernanke suggested the central bank could begin to reduce, or taper, its $85 billion in monthly mortgage bond and Treasuries purchases. The potential for a change in policy has increased the conflict between bulls and bears who say the stock market has been artificially inflated by the Fed.
The value of all American equities has contracted to $19.3 trillion from $19.8 trillion at the peak, according to data compiled by Bloomberg. Capitalization of shares on global markets is $55 trillion, down from $58 trillion four weeks ago.
The S&P 500’s decline since reaching a record has been led by utilities, whose dividend yields lured fewer investors as Treasury 10-year rates climbed above 2 percent. Oneok Inc., the Tulsa, Oklahoma-based power provider, lost 10 percent and FirstEnergy Corp. in Akron, Ohio, slid 13 percent since May 21.
Equities usually gain when the Fed reverses course and starts to make money more expensive, signaling the economy is strong enough for policy makers to place inflation-fighting above growth concerns.
U.S. gross domestic product has expanded an average of 3.8 percent in years when the Fed began tightening, compared with an annual rate of 2.8 percent since 1971, according to data compiled by Bloomberg. Profits will jump more than 10 percent in each of the next two years after almost doubling since 2008, more than 11,000 analyst estimates show.
The S&P 500 gained 10 percent over two years starting in 1983 and 7.4 percent in 1987 after the Fed reverses policy. It jumped 35 percent between February 1994 and February 1996 and 11 percent two years after the Fed started raising rates in June 2004, according to data compiled by Bloomberg.
Bears say history is no guide now because stock prices already rallied too much, given the state of the U.S. economy. The S&P 500’s 87 percent advance since the rate on overnight loans between banks was pushed to zero in December 2008 is more than five times the average advance in periods following monetary easing, data compiled by Bloomberg show.
Stock market volatility has been higher this year than during past periods when the Fed reversed policy. Daily moves for the S&P 500 have averaged 0.68 percent since March, compared with 0.48 percent for the first quarter, according to data compiled by Bloomberg. In the month before the Fed tightened in 1994 and 2004, daily price changes averaged 0.44 percent.
The S&P 500 plunged 1.4 percent on May 31 as better-than-forecast data on business activity and consumer confidence led to concern the Fed would pare its stimulus measures. The index gained 1.3 percent, the most in about seven weeks, on June 7 after the Labor Department said American employers added 175,000 jobs in May, exceeding economists’ forecasts.
“People are playing the what-if game on whether the Fed will taper,” Dan Veru, chief investment officer at Palisade Capital Management LLC, said in a June 12 phone interview. The Fort Lee, New Jersey-based firm manages $4.2 billion. “That’s why the market’s been so choppy. When investors don’t know what’s going on, they get out of all risk assets until they understand what’s happening.”
The employment report showed the automatic across-the-board federal spending cuts, or sequestration, that began in March are having an impact on government payrolls. Jobs created by the whole economy, including federal agencies, averaged 155,300 the last three months, compared with 170,500 from 2002 to 2007 and 1990 to 2000, data compiled by Bloomberg show.
“I think what we’re realizing is sequestration is going to last a little bit throughout the year, it wasn’t all concentrated in April, May,” Adam Parker, chief U.S. equity strategist at Morgan Stanley (MS:US), said in a June 4 Bloomberg Television interview. “That’s probably a risk to the downside in the second half.”
Removing Fed stimulus at the same time the government is cutting spending will hurt stocks, according to Bruce McCain, who helps oversee more than $20 billion as chief investment strategist at the private-banking unit of KeyCorp in Cleveland. The U.S. budget deficit widened in May to about $138.7 billion from a year earlier on a 10 percent increase in spending, according to Treasury Department figures June 12.
“If the Fed cuts back what they’re buying more rapidly than the deficit declines, then they would effectively be drawing liquidity out of the markets and that would weigh on prices,” he said in a June 13 phone interview. “If we are as extended as we have been, as they begin to withdraw their stimulus that would lead to perhaps a fairly nasty correction.”
Even with the advance, mutual-fund customers have retained their preference for fixed income, sending $18.3 billion to bond managers in May and withdrawing $5.4 billion from U.S. stock funds, data from the Investment Company Institute show.
“If you want to see the impact of tapering you only have to look back to the last couple of weeks,” Lawrence Creatura, a Rochester, New York-based fund manager at Federated Investors Inc., which oversees about $380 billion, said in a June 13 phone interview.
More than $11 trillion has been added to American share values over the last four years as Bernanke held interest rates near zero and carried out three rounds of bond purchases to stimulate growth, a program known as quantitative easing. The S&P 500’s advance since March 2009 is bigger than in every developed country except for Denmark.
Even with the rally, earnings have risen so much that valuations remain below historical averages. Stocks trade at about 15.9 times reported operating earnings, compared with the mean of 16 in data going back to 1954. The S&P 500 traded at about 10.5 times annual earnings when it reached a 12-year low in March 2009.
“Although the market has significantly appreciated, it was significantly oversold heading into that rally,” Eric Teal, chief investment officer at First Citizens BancShares Inc., which manages $5 billion in Raleigh, North Carolina, said in a June 13 phone interview. “Corporate earnings have really been the drivers of higher stock prices up to this point, and if we anticipate economic growth then the market can continue to do well.”
Utilities, which have dividend payouts about twice as high as the S&P 500, slumped 5.8 percent since May 21 as rates on 10-year U.S. notes rose as high as 2.29 percent on June 11. Oneok, which yields 3 percent, plunged 10 percent since May 21. The stock trades at 35 times reported earnings. FirstEnergy, a nuclear power plant owner, has a dividend yield of 5.7 percent and is down 13 percent since Bernanke’s comments to Congress.
Phone stocks, which also pay high dividends, are the most expensive industry in the S&P 500. Windstream Corp. (WIN:US), the landline telecommunications company that has the highest dividend yield of the S&P 500, has lost 5.5 percent since May 21. The Little Rock, Arkansas-based company is 33 percent more expensive than the S&P 500, with a price-earnings ratio of 21.1, according to data compiled by Bloomberg.
Stocks whose earnings are most tied to economic growth have led gains this quarter, with financial shares up 7.1 percent, a sign investors are betting on more growth and consumer spending. Morgan Stanley, in New York, advanced (MS:US) 18 percent, while Fifth Third Bancorp., Ohio’s largest lender, rallied 12 percent.
Economists are more optimistic about the economy in the next two years, with the median forecast at 2.7 percent for 2014 and 3 percent for 2015. GDP has expanded an average of 2.1 percent a quarter since the recession ended in June 2009, less than half the average in recoveries since 1945, according to data compiled by the Commerce Department and Bloomberg.
“The Fed is clearly going to wait and gauge the sustainability of the economic recovery,” Teal said. “And the improving economic growth signs outweigh the monetary tightening impact. That will likely be the case this time.”
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