Russell Investments Blog

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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This is the first of two blog entries giving Erik Ristuben’s perspectives on the markets at mid-year. The second installment will be posted later this week.

On June 4, 2013 I was watching TV while preparing for an upcoming interview on the same network. These interviews often provide me with an opportunity to sit back and look at economic or market data and add perspective to the daily grind.  Midway through my preparation I realized that last year’s “sell in May” market bottom occurred exactly one year earlier, on June 4, 2012. How have we travelled since then?

Looking at the data for this past year revealed things that I knew to be true, but the numbers are startling when put in black and white. In some cases people may be surprised by the numbers, both in terms of magnitude but also in terms of the relative performance of various markets.  Here is what I saw when I looked at the numbers over the period of June 4, 2012 to June 4, 2013:

• Global Developed Market Equities were up 31.31% (Russell Developed Large Cap® Index net)
• U.S. equities were up 31.16% (Russell 3000® Index)
  • Russell 1000® Index was up 30.84%
  • Russell 1000® Dynamic Index was up 34.40%
  • Russell 1000®  Defensive Index was up 27.39%
  • Russell 2000®  Index was up 35.11%
  • Non-U.S. Developed market equities were up 32.84% (Russell Developed Large Cap® Index)
  • Emerging markets were up 18.82% (Russell Emerging Markets® Index net)
  • Barclays U.S. Aggregate Bond Index was up 0.75%

Unquestionably, equities were the way to go over the last year, and not by a little bit, and the question I’m often asked is “How about next year?”  And increasingly, investors have been asking this question in light of the last couple of weeks’ market performance, in which the Russell 1000® Index has sold off on what can be correctly characterized as higher than recent history volatility.

So can equities win over the next year as well? My response: I like equities because I still hate cash.

My view on the markets is based on the continuation of the global economic recovery/expansion, most notably the United States. This is important for many reasons but notably because this kind of economic environment often allows the markets to focus more on fundamentals and less on “risk on/risk off” driven by the relative probability of end of civilization as we know it.

Here is the fundamental argument for equities.

1. The Fed has promised me a zero rate of return until unemployment reaches 6.5%.
2. The Fed has told me to expect 2% inflation.
   1. Therefore: I expect a negative 2% real return from cash.
      1. This is hardly a compelling investment case to own equities.
3. Russell believes there is upward pressure on interest rates.
   1. When yields go up, bond prices come down.
   2. Therefore: we expect that the Barclays U.S. Aggregate Bond Index will have a zero rate of return over the next year.
4. We also believe that modest global economic growth will continue at a 3-4% annual rate.
   1. In our view, this will result in modest growth in earnings per share (EPS).
      1. This EPS growth, in our view, will be supported by stock buyback programs.
   2. The dividend yield of the Russell 1000® is a little over 2%.

Let’s conservatively estimate that the combination of economic growth, operational leverage and the impact of buyback programs are enough to increase earnings per share on the Russell 1000® Index by 4% over the next year (which is less than half of current market consensus EPS expectations). If this happens, then I think it is entirely reasonable to expect a 6% rate of return from equities over the next year: 2% dividend yield plus 4% EPS growth. We may get more or less, and I think the risk is to the upside, but I do not need more in order to be right.

The threats to this forecast are obvious: Europe, U.S. fiscal contraction and China’s growth rate, to name the top three. Other threats loom as well, many that we can’t see, but that is always how the world looks. Bad things are all too possible, it’s just that reasonably good things seem to be more probable to me. Everything is possible; we invest in what we think is probable.

Six is bigger than zero. I like equities because I hate cash. Still.

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