Return of a stock-picker's market

Saira Malik, Head of Global Equity Research, TIAA-CREF

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We have a positive outlook for stocks this year as economic momentum in the housing, jobs and manufacturing sectors should provide a strong underpinning for further price growth, though there remains risk of a short-term correction. We're equally encouraged by a pair of trends that should also lead to improved conditions for fundamental, research-focused stock selection: declining stock correlations and a reversal of flows from equities.

Since the financial crisis in 2008, we’ve witnessed higher-than-normal stock correlations, or the degree at which stocks move together, as markets have been swayed by major economic events, such as the bursting of the housing bubble or the eurozone debt crisis, rather than by company-specific or fundamental factors. Instead of choosing individual stocks based on their underlying fundamentals, investors tended to trade the market as a whole, reacting day-to-day to the latest headlines. This has changed in recent months, however, as we’ve seen markets “normalize” somewhat and many more stocks trading on fundamentals again.

Article Highlights

  • Our outlook for stocks remains positive, though risk remains for a short-term correction.
  • Conditions for fundamental, research-focused stock selection have also improved: Declining stock correlations and strong equity inflows have led to improved conditions for fundamental, research-focused stock selection.
  • We’ve seen positive economic momentum in housing, labor and manufacturing.
  • Risks include higher taxes, U.S. federal government spending cuts and potential for rising gas prices.
  • In selecting stocks that we believe will outperform the market we focus on underlying company fundamentals such as strong free cash flow and the ability to generate profit by introducing new products or by raising prices.

The flow of money back into the equity market can also be a major boost. After a five-year period, from 2008 to 2012, in which retail investors moved about $550 billion out of equity funds and put about $1.2 trillion into bonds, we’ve seen money flowing backinto stocks, although bond inflows also remain strong. More than $40 billion has flowed into stock funds early this year.

Figure 1: Strong flows in stock funds

Primary asset classes include equities, fixed income, money market, guaranteed, and real estate

Source: Haver Analytics and the Investment Company Institute, as of April 2013.

Economic momentum: A three-legged stool
In addition to positive fund flows into equities and the return of favorable stock-picking conditions, an improving economy is creating a strong underpinning for the stock market. We see the economic recovery as a three-legged stool.

1 – Housing market recovery. The housing market had been a laggard during the early stages of the current economic recovery, and a reason why it has been the weakest in the post-World War II era. Housing typically leads the economy after recessions, posting strong gains and driving growth. We are seeing a turnaround, however, as there have been many positive developments in housing. We've had six consecutive quarters of housing start gains, for example, and there is room here for more growth. Home sales have also increased in recent months, including sales of new homes, which increased 28% and existing home sales rose by 9.1% in January.

Housing prices are also improving, up about 5.5% over last year. Rising home prices produce a consumer “wealth effect,” which may lead to greater spending.

2 – Healthier labor market. The U.S. unemployment rate has dropped in recent months to 7.7%, but is still historically high and labor data remains mixed. One key indicator is the trend in initial unemployment benefits claims. When the four-week moving average of claims is above 400,000, it signals a weak and contracting labor market. But when the four-week average is consistently below 350,000, that’s been a signal that the labor market is expanding. The average peaked at around 660,000 in March 2009 at the height of the “Great Recession,” but since then has been edging down, and has been in expansion territory for a while, a sign of growing stability. And that’s good news for consumer confidence and market sentiment.

3 – Expansion in manufacturing activity. The third leg of the stool is expansion of manufacturing activity, which has mostly been in expansion territory since the end of June 2009. A key indicator to watch for manufacturing health is the Institute for Supply Management’s Purchasing Manager’s Index, a monthly figure that shows whether the sector is growing or contracting. A reading above 50 indicates that manufacturing is increasing, while a reading below 50 indicates contraction. According to the index, manufacturing activity has stayed in expansion territory over the last several months.

The news sounds great: But have we missed the party?
Considering strong equity flows, an improving economy and headline-grabbing stock market highs, some may wonder if the current rally has peaked. We believe it has room to run, as economic momentum in key sectors should continue and as equity valuations continue to remain below historical norms, as shown in Figure 2. The median price/earnings ratio for the S&P 500, for example, was a little under 16 in early March, which compares favorably to its 20-year average of about 17.3.

Figure 2: Valuations and economic indicators support further earnings expansion

Primary asset classes include equities, fixed income, money market, guaranteed, and real estate

Source: FactSet, as of April 2013.

Overall, we see encouraging signs. But risks always exist.

Headwinds: Higher taxes, gas prices and spending cuts
Over the short-term, consumers face a trio of potential obstacles, including higher taxes, gas prices and spending cuts. Higher taxes and U.S. federal budget cuts are problematic but temporary, which may be a silver lining. Economic growth is projected to slow during the second and third quarters this year, but we don’t expect the net effect on the overall economy to be too damaging. We expect the budget cuts, or “sequestration” in Washington lingo, will reduce GDP by about 0.5%, but that overall growth for the year should be around 2%.

Higher taxes are hurting people at all income levels. Households are paying 1.8% more in taxes, on average, which equates to about a $1,300 reduction in take-home income for the typical household.

Higher gasoline prices are another factor. Gas prices have been falling in recent weeks, though they merit close monitoring as they are a driver of both economic growth and consumer sentiment. Every 25-cent increase in the price of a gallon of gasoline reduces real GDP by about 20 basis points, or 0.2 percentage points. Prices peaked this year at $3.79 a gallon in February and are down about 20 cents since then, but have remained elevated since 2010 when prices were under $3 per gallon.

Short-term versus long-term focus
While consumers have less money to spend because of lower take-home pay and the gas price squeeze, we see these as short-term factors. Judging from recent consumer spending patterns, the wealth effect appears to have offset the short-term pain experienced by consumers early this year. This is seen in the steady rise in consumer spending (Figure 3) despite mixed reports on consumer confidence.

Figure 3: Consumer spending remains in an upward trajectory

Primary asset classes include equities, fixed income, money market, guaranteed, and real estate

Source: Bureau of Economic Analysis, as of April 2013.

Global view: Europe, China and Japan
Europe continues to struggle with unresolved issues. In some countries, burdened by high levels of debt, austerity is seen as painful but necessary medicine, but it has been a deterrent to growth. The recent bailout of Cyprus, for example, should help stabilize the nation’s banking system, though the austerity measures could cause its GDP to contract by a cumulative 12.5% in 2013-14.1 Italy has also been of particular concern recently, with questions about its ability to form a coalition government at a critically important time. We believe investors should take a long-term view of Europe, and focus on companies that have the best chance of generating profit and strong cash flow.

In Asia, Japan has caught the attention of investors. After languishing for years, its stock market has perked up in recent months, driven by the new government’s aggressive campaign to weaken the yen and improve opportunities for the country’s export-driven economy. However, given the history of previous failed attempts at stimulating Japan’s lethargic economy, we are waiting to see signs that the necessary execution will take place. Until we see fiscal stimulus, deregulation and structural reforms that could really take Japan to the next step, we believe that the market has already priced in a lot of optimism.

Figure 4: Emerging markets underperforming in 2013

Primary asset classes include equities, fixed income, money market, guaranteed, and real estate

Source: FactSet, as of April 2013. It is not possible to invest in an index. Performance for indices does not reflect investment fees or transaction costs.

China remains a mystery. Its GDP growth rate is down a bit from its peak levels of 2010, but it is still strong. China is going through a transition where the government is trying to redirect the economy to one that is more consumption-driven, rather than reliant on heavy investments in fixed assets. Further complicating things is the rise of inflation, which limits the pace at which the economy can safely grow. On top of that, real estate speculation has grown. The government has to be careful not to slow things down too much. So, it’s a delicate balance. While we continue to see excellent long-term prospects in China, we’re cautious about its current challenges.

On the road to new insights
Fundamental research and good stock picking are naturally enhanced through in-person visits to see companies in operation. Not only that, when you have teams of well-informed individuals collaborating freely, it improves the flow of information and the ability to make smart, timely decisions.

The TIAA-CREF equity team of 40 global research analysts and 30 portfolio managers works closely together to share the breadth and depth of their research and insights. This particularly came into play on an Asian road trip in which three analysts and three portfolio managers traveled together to Korea and Taiwan in search of a detailed view of the Asia technology supply chain.

The goal was to identify the future winners and losers in the most dynamic market niche today, the development of next-generation smartphones and tablets. The experience was positive, productive, insightful and a great example of a team that works closely together to find timely investments in stocks with potential to outpace the rest of the global equity market for years.

Summarizing our global equity outlook, while we can’t ignore the potential for a short-term market correction, or the possibility that short-term factors that briefly curtail U.S. economic growth, we believe that major trends will continue to support propel global equities further. More importantly, we’re encouraged by trends that indicate improved conditions in which research-intense stock-picking will be rewarded.

In selecting stocks that we believe will outperform the market, we focus on key factors, such as companies with strong free cash flow and the ability to generate profit by introducing new products or by raising prices.

Many risks and opportunities in stocks today
There are many events in motion, and any one of them has the potential to derail or at least threaten the current rally. Key spending and taxation issues, not to mention the debt ceiling, are still on the table in Washington D.C. An unexpected exit from the eurozone or a North Korean attack are examples of “tail risks,” or statistically unlikely but possible events that would pose a major shock to the system and change the outlook for equities. While we view such scenarios as low-probability events, there always exists the potential for an unforeseen event to affect markets.