After a rocky first few weeks of the year, U.S. equity markets fell sharply last week. The media blamed much of the decline on market turmoil in emerging markets. China reported some surprisingly weak economic data, and financial turmoil in Argentina and Turkey led to a sell-off in EM currencies.
But while EM volatility certainly contributed to investor angst, I believe last week’s equity market sell-off had more to do with two other factors, as I write in my new weekly commentary.
1. Stretched Valuations. Last year’s gains were powered mostly by multiple expansion – investors were willing to pay increasingly more for a dollar of earnings. In fact, 2013 saw the largest single-year increase in market valuations since 1998. In addition, not only did stocks become more expensive, but bonds became cheaper. As a result, many large institutions are rotating back into bonds, contributing to pressure on equities.
2. Domestic issues. Last year’s rally was largely an act of faith that the economy and earnings would improve, justifying higher stock prices. While the economy does appear to be mending, the improvement has been modest and gains are not yet evident in earnings numbers. It’s still relatively early in the fourth-quarter reporting season, and to date, the results have been respectable, but hardly inspiring. The percentage of companies that are reporting better-than-expected results is actually below the four-year average.
Investors’ growing frustration with earnings results is evident in recent flows. U.S. equity funds have been seeing outflows, while European and global equity funds have been attracting assets.
So what does this mean for investors and their portfolios? While I still think that stocks will post gains this year, those gains are likely to be more muted and accompanied by more ups and downs. As the Federal Reserve tapers, market volatility is likely to revert back to its longer-term average. As such, investors should consider preparing their portfolios for the rockier road ahead.
In addition, in a week when much of the news was negative, Europe surprised to the upside with a big surge in manufacturing. So, for investors that have focused on the United States, I advocate looking to increase international exposure to the other large developed economies, specifically Europe and Japan. In fact, I now hold overweight views of both markets.
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The views expressed here are that of myself or the cited individual or firm and do not constitute a recommendation, solicitation, or offer by myself, D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.
The Jacksonville Business Journal has ranked D2 Capital Management in the top 25 of Certified Financial Planners in Jacksonville. The Firm is also a member of the Financial Planning Association of Northeast Florida, the Jacksonville Chamber of Commerce, the Southside Businessmen's Club, and the Beaches Business Association.
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