Soft Data Aren't Spooking Markets—Weekly Market Review
Though scholarly opinions differ on the historical origins of Halloween, one theory suggests that in Celtic-speaking countries of old, the holiday marked the end of the harvest season and the beginning of the “darker half” of the year. Many global economic indicators appear lackluster (as was to be expected in the aftermath of the government shutdown and debt ceiling uncertainty) and U.S. stocks are pushing all-time highs, but while the pace of returns may slow from the rampant pace of the last five years, I do not believe that the harvest is over for investors.
Last week the S&P 500 Index gained for the third week in a row, helped by a spate of solid third-quarter earnings reports—and apparently unfazed by weaker than expected data on employment, capital spending, housing and consumer sentiment. Despite having gained 25.5% so far this year,1 valuations don’t look excessive, and we’re seeing leadership from some key early-cycle sectors, such as transportation.
So why are stocks going up when the economic data is mostly going sideways? First, in the wake of the summer’s “taper tantrum,” we currently live in a world where good news for the economy can be bad news in the eyes of investors, at least in the short run; strong economic numbers, the logic goes, could trigger a reduction in the Fed’s large-scale asset purchases—an exaggeration, in my opinion, of how much monetary policy is “artificially” buoying equity prices. Secondly, many other asset classes hold little appeal at the moment compared to stocks, notably including Treasuries and commodities. Third, markets are forward-looking. They care more about whether things are getting better or worse than they do about whether conditions are currently good or bad, and corporate earnings continue to get generally better.
No Nightmare on Wall St. Despite Weaker Data
The key question, then, is whether things are indeed getting better. By and large, the recent economic data have pointed to slow, but positive, growth and a gradual end to the deleveraging process that we’ve been living with since the financial crisis began over six years ago. To the extent that lackluster economic data (with an assist from the government shutdown) likely push the beginning of Fed tapering well into next year, financial markets seem to be okay with slow growth. At some point, however, fundamentals do matter, and markets will want to see improving earnings with stronger revenues pushing them ahead. On this issue we’re still waiting for the harvest to turn bountiful.
Last week finally saw the release of the September payrolls report, which had been delayed because of the government shutdown. The economy added 148,000 non-farm jobs, a smaller number than expected, after having added 193,000 in August. Private payrolls rose 126,000—again fewer than in August—led by solid hiring in professional and business services, construction, and wholesale trade. In an encouraging sign, we continue to see renewed hiring by local governments, which had been firing workers en masse for several years after the financial crisis amid budget constraints.
The data were a somewhat disappointing surprise, especially given a strong ongoing decline in layoffs and surveys showing rising hiring plans among small businesses. Companies’ balance sheets are in generally strong shape, and they have very little “fat” left to trim. And yet, companies are still not willing to spend much money either to hire or upgrade aging capital equipment. Last week brought news that while durable goods orders rose by the most in three months in September, the gain was entirely due to increased demand for military and civilian aircraft—a notoriously jumpy category. More worryingly, orders for non-defense capital goods excluding aircraft (“core capex”), a proxy for capital spending—fell 1.1% in the month, while shipments of the same fell 0.2%. Over time core capex is closely correlated with the performance of the S&P 500 Index. Should this volatile indicator enter a downward trend, caution would be warranted.
While spending money on new hires or new equipment hurts corporate earnings in the short term, one company’s expenditure is someone else’s paycheck. And paychecks are, unfortunately, in shorter supply than we’d like. Wage growth is still fairly stagnant, so demand for goods and services is still far from robust, too.
So why are we seeing this mixture of at first promising but then disappointing economic results? What’s still lacking, in my view, is one of economists’ more colorfully named variables: animal spirits—the willingness to take risks in the expectation of better things to come. Headwinds of uncertainty, especially with regard to government policy, appear to inhibit risk taking by both businesses and consumers. There’s plenty of anecdotal evidence that businesses and the lobbies that represent them were spooked by the government shutdown and the threat of a debt ceiling breach. I often say that hating the government is not an investment strategy, but for some businesses, it apparently is.
On the consumer side, consumer confidence has taken a major hit since the end of the summer, at which point it was quite robust. The Thomson Reuters/University of Michigan consumer sentiment index fell to a 10-month low in October, according to data released last week. A gauge of six-month expectations dropped to its lowest level in two years—despite the price of gasoline (often a strong correlate with consumer happiness) being near its lowest point of the year. Many of us have strong views about what the government should and should not do, but I expect that we’d rather have the certainty of policy we disagree with than uncertainty about policies that could shape our borrowing, spending and investing decisions.
Revenues Still Trailing Earnings
And so we are seeing yet another quarter in which lean-and-mean companies are able to grow earnings and handily beat (previously lowered) quarterly earnings expectations, while falling short on revenue growth. Among the 244 companies in the S&P 500 Index having reported through Friday afternoon, 79% met or exceeded earnings expectations (well above the long term average), but only 54% had met or exceeded revenue expectations.
Among the sectors with the highest proportion of revenue surprises so far are consumer discretionary and healthcare, while utilities have seen among the widest sales misses. Interestingly, today’s markets are not heaping disproportionate laurels on companies that deliver “organic” earnings growth—that is, growth derived from higher sales as opposed to cost containment. So far equity markets continue to anticipate acceleration in the real economy even as it pauses, but in the medium term, I would expect markets to become more selective as the companies that can accept the risks of growing both sales and profits to outperform.
1 Source: Bloomberg, 10/25/13. Past performance does not guarantee future results.
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