Weekly Market Summary

The second quarter ends Monday. Over the past three months, equities underperformed bonds by 180bp. Utilities and energy were the equity sector leaders. Defensive sectors mostly beat cyclicals.

This follows the pattern from the first quarter. Thus, over the first half of 2014, equities have underperformed by bonds by a massive 560bp. Utilities have outperformed SPX by nearly 3 times. Cyclicals have lagged.

Fund Managers' Current Asset Allocation - June

Every month, we review the latest BAML survey of global fund managers. Among the various ways of measuring investor sentiment, this is one of the better ones as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $700b in assets.

In June, fund manager equity weightings increased in every region in the world. Exposure is now +48% overweight, the highest since January.

What has been remarkable is how long managers have been highly overweight equities (virtually since the start of 2013). This is longer than any period during the 2003-07 bull market (yellow shading). In the past, after massive overexposure like that seen in the past 18 months, a washout low would be marked by an equity weighting under +15% (green circles). By that measure, equities are still over owned.

Weekly Market Summary

Trend, breadth and volatility are the primary tailwinds to the rally.

SPX and DJIA have both risen 10 out of the last 12 days. SPX has made nine all-time highs (ATH) in the past 11 days. DJIA, NDX, the Euro 350, and the All World Ex-US index are all at bull market highs. EEM is at an 18-month high.

Meanwhile, lagging breadth has been repaired. 88% of SPX companies are above their 50-dma, the most since May 2013. Among the nine SPX sectors, seven are at bull market highs.

June Macro Update: Still Moderate Growth

Last month we reviewed all the main economic data (post). Our key message was that (a) growth is positive but modest, in the range of 3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.

This post updates the story with the latest data from the past month. The overall message remains unchanged.

We'll focus on four categories: labor market, inflation, end-demand and housing.


Employment and Wages
The May non-farm payroll (217,000 new employees) was in the middle of a 10 year range. This follows prints of 84,000 in December and 282,000 in April. Moving between extremes like these has been a pattern during every bull market. Since 2004, every NFP print near or over 300,000 has been followed by one near or under 100,000 (circles).

Historically, A Decline In Earnings Caused P/Es to Spike Higher Than They Are Today

In a recent post, we looked at factors, including valuation, that will drive SPX returns over the next 12 months (post).

Since the late 1800s, SPX trailing 12 month (TTM) P/Es have been a median of 14.5x. In comparison, current "as reported" P/Es are 19x through 1Q14 (source).

19x is quite high. Between April 2005 and September 2007 - the heart of the prior bull market - P/Es never exceeded that level.

Yet, it's generally assumed that P/Es go higher than 19x (into the 20s) during bull markets. A look at the chart below seems to confirm this.

June 2014: What Will Drive SPX Higher in the Next 12 Months?

Last September we asked what fundamental factors could drive SPX higher in the year ahead (post). We considered three variables: sales growth, margins and valuation. Our conclusions were the following:

• Sales growth had been about 2% since 2011 but with better overseas growth could rise to 4% in 2014. 
• Margins were 9.5%, at 70 year highs, and were unlikely to expand further. Labor and interest costs were likely to become headwinds. 
• Valuations were average at 15.6x and an unlikely source of substantial upside potential.

Since then, SPX has risen about 15%. What has been the source of this growth?  The short answer is valuation.

• 70% of the gain is due to multiple expansion, which increased to 17.2x. Without this expansion, SPX would be near 1730 instead of 1910
• Sales accounted for only 2% growth (or 10% of the gain). 
• Margins expanded slightly, from 9.5% to 9.7%, enough to add 3% to growth (or 20% of the gain).

The question now facing investors is what will drive the market higher from here. The short answer is sales:

• Sales are likely pace index appreciation. The consensus of 3-5% sales growth is reasonable based on recent data.
• Margins have already flattened. Further margin expansion seems unlikely. 
• Valuation is now well above average. Even on generous assumptions, the market is above 'fair value' of 1900 for year end 2014 already. 

Let's take each variable in turn.


Sales growth
Sales growth continues to be the bright spot for fundamentals. Unfortunately, as we discussed in September, it has the lowest leverage on future returns of the three variables. Margins and valuations both have much higher leverage.

Trailing 12-month sales growth was 2.3% in 3Q13; that has moved up to 2.8% in 1Q14. The consensus is expecting 3.4% for FY14 and 4.3% for FY14. 3-5% growth is reasonable and also fits with recent macro data (post). Current growth is, it should be stressed, much lower than during the prior bull market and the forecast is for an acceleration during the 6th year of an expansion, which is unusual.