The market high for the Russell 1000® Index of 926.08 occurred on May 21, 2013. At the close on June 5, 2013 it was at 891.24, representing a 3.8% decline. What do we make of this pullback? To answer that question, I will remind clients of what we have been saying since the end of the first quarter, which is: “We believe you should be fully invested in equities and braced for a pullback of 10% or more. Meaning, if you are supposed to own 60% equities, you should own 60% equities and be prepared for volatility.” Of course, individual investors will want to work with their advisors on what is best for them, as individual circumstances will vary.
There were many reasons we believed that a pullback of this magnitude was possible—most notably because of our observation of history, which clearly tells us unequivocally that an intra-year decline of that size happens in most years. In fact, based on the Russell 1000® Index, it has happened in each of the last four years. My main argument against such a fall was simply that everyone was saying that a pullback was inevitably going to occur. When everyone says something has to happen, it very rarely does.
What is causing the pullback, and is it “for real”? Clearly the pullback is real, but is it based on fundamentals or current short-term sentiment?
No one can know for sure why the market animal spirits are currently pushing the market down, but I will share my theory. I think the market is dealing with a couple of gear changes, namely in the economy and in potential Fed policy. The economic numbers – things like consumer spending and PMI manufacturing surveys – we have seen in the last couple of months look modestly weaker than the in the first three months of the year. That said, the most recent numbers – things like the employment number and housing – largely indicate improvement in the economy.
Regardless of how I look at the economic data, I arrive at the conclusion that the U.S. economy continues to grind along in the “square root” shaped recovery that Russell’s Chief Economist, Mike Dueker, predicted in November of 2008. Therefore, I do not believe this sell-off has been driven by a market that is concerned about economic growth being significantly worse than we saw in the first quarter of each of the last four years. Ironically, the most likely cause of the pullback is directly related the market’s growing comfort with the improving relative health of the U.S. economy. Is this a case where good news is bad news? If so, how does that work?
Here’s how I believe the market is getting there. If the Fed has been supporting the U.S. economy through Quantitative Easing (QE) with a goal of getting it healthy enough to survive or even thrive on its own – and if the economy is undeniably healthier than it was – then will the Fed remove the support sooner than we and others expected? And what will happen if that support is removed “too soon”? I believe that last question is the truly important one. Again, the answer is that no one knows what will happen when the Fed “tapers” QE on the way to stopping it entirely, let alone if they do it too soon. The unknowable equals uncertainty, and uncertainty means more market volatility.
One of the first questions investors should ask themselves, then, is “how likely and how soon will the Fed start tapering?” In my mind, it is not that likely, particularly if you think that “soon” means in the next three months. I have several reasons for this belief, in particular the Fed’s dual mandate of price stability and full employment. Think inflation and economic growth. To me this means that if the Fed thinks that inflation doesn’t represent a clear and present danger, then they can focus on growth.
No measurement, of anything, in the U.S. economy gives any indication that inflationary pressures are currently significant. Rather, I believe deflationary pressures seem to pose a more immediate threat. Therefore, the Federal Reserve is relatively free to concentrate on maximizing the U.S. economic growth rate in order to get full employment, which it has defined as an unemployment rate of 6.5% or less. We are at 7.6%, and inflation can’t be seen.
The Fed has been working hard for the last five years to heal the economy and has kept its foot firmly planted on the accelerator for the entire time. Why would it take its foot off the accelerator “too soon” when there are no inflationary pressures? Why would the Fed inject that level of uncertainty/risk that may threaten the good work that it has done for the last five years? In my mind, the bigger risk is that the Fed is “too late” rather than “too soon”. I believe any deceleration is much more likely to happen couple of years from now, not this summer.
Russell continues to believe the following: own stocks, because fundamentally relative to cash and bonds they look more attractive, and brace yourself for the pullbacks that “inevitably” will occur.
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