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Note: Unless otherwise specified, currency amounts described in this article are in U.S. dollars, and government references are to the U.S. government. Schwab Market PerspectiveLiz Ann SondersSenior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc. and Brad Sorensen CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research March 26, 2010 Key points
Concerns are elevated about low volume and diminished volatility, signs of complacency. However, the grinding-higher action that has resulted is certainly no disappointment. Schwab's philosophy rests on a long-term investment horizon of at least three to five years, with special attention to diversification and rebalancing. Despite the aforementioned concerns, the market has moved through important resistance levels while setting new 52-week highs. Yet many investors remain on the sidelines as the market continues to grind higher. With the renewed rally, investor sentiment has moved back into the optimistic zone (a contrarian indicator). In addition, close to 90% of stocks in the S&P 500 were recently trading above their 10-week moving averages—a higher percentage than we saw prior to the January correction—resulting in the possibility of a near-term pullback. We would continue to view mild corrections as a healthy part of any cyclical bull market and remain relatively optimistic on near-term prospects of the market continuing to grind higher. Low volatility, as measured by the Volatility Index (VIX), is of concern to traders. It’s often espoused that low volatility can’'t last forever, is a sign of complacency and can lead to a corrective phase for the market. The inability to predict short-term market movements notwithstanding, the chart below shows that the market can continue to trend higher during sustained periods of low volatility. Stock market can move higher during low-volatility periods  Source: FactSet, Standard & Poor's, Chicago Board Options Exchange, as of March 23, 2010 Economy mirroring market? Recent economic releases have been healthy but muted, showing the recovery is ongoing, but at a less-frenzied pace than might have been suggested by the depth of the prior downturn. Industrial production rose again as manufacturing continues to lead economic growth, initial unemployment claims resumed their descent, and the residential and commercial real estate markets continue to stabilize. Additionally, the Index of Leading Economic Indicators posted its 11th straight monthly gain in February. However, it does appear that the United States continues to transition to a more sustainable rate of growth versus the V-shaped growth we saw last year. The LEI appears to be flattening out, which could mean more grinding action for the market this year. LEI indicates a moderating growth rate  Source: FactSet, US Conference Board, Standard & Poor''s as of March 23, 2010. Jobs remain top-of-mind as the unemployment rate remains near 10%, casting doubt on the sustainability of the recovery—especially on the consumer front. We were pleased with the better reading this week on jobless claims, but they remain too high for comfort. In addition, weather and Census hiring will continue to cloud the various employment readings for the next couple of months. However, we remain confident that we'll start to see sustained job gains as soon as the March labor report, for which economists' expectations are as high as 200,000 jobs created. Temporary employment has increased substantially, corporate profitability is on a tear, employment components of various manufacturing surveys have improved, and demand for products and services is increasing—all good leading indicators for job growth. Fed sticks—but are hints of change emerging? Despite the Federal Reserve upgrading its assessment of the labor market to "stabilizing" from the "deterioration is abating" phrase in the previous statement, the Federal Open Market Committee (FOMC) decided to keep fed funds target rate unchanged at 0%-0.25%, while also committing to keeping rates at "exceptionally low" levels for an "extended period." That last phrase is being keyed in on as one that will likely be changed prior to any possible rate hikes. In fact, as Liz Ann has recently discussed, several Fed speakers have moderated that language in speeches, possibly indicating a slow change in views among members of the FOMC. Additionally, while the Fed hasn't raised rates, it has allowed several other stimulative measures to expire while reiterating its commitment to ending purchases of mortgage-backed securities at the end of March. However, the Fed appears to be under no inflationary pressure to raise rates. Slack in the economy remains, with unemployment remaining high and wage pressures virtually non-existent. Additionally, the recent reading on capacity utilization moved up to 72.7 in February, though it remained 7.9 percentage points below its average between 1972 and 2009. Although inflation may become a concern in the future, it appears to be a very minimal risk currently. Prices at the consumer level came in flat month-over-month in February based on the consumer price index report, while, when stripping away more-volatile food and energy prices, the core rate bumped up a mere 0.1%. Despite the lack of inflation concerns currently, we continue to believe that rates will, and should, start to go up before many in the market are now expecting. The zero-rate policy was put in place in response to a financial emergency which seems to be well past. Moving slowly to a more-normal level of interest rates seems appropriate, and we would be more concerned if economic conditions warranted continued emergency levels. Fiscal concerns Likewise, we'd like to see the federal government slowly start to step away from its involvement in the day-to-day dealings of the economy. The recent bipartisan passage of another $18 billion jobs bill is likely to add to the deficit, with uncertain actual impact on job growth. And while rhetoric surrounding the problem of growing deficits at the state and federal levels continues to escalate, there is yet no firm plan to address the issues. However, while we acknowledge the debt problems in the United States, we aren't singing the same dour tune as many on Wall Street. The ingenuity and entrepreneur attitude of this country has pulled it out of tough times before, and for now we continue to believe that aspect has been overlooked as a way of growing out of the deficit problems. In addition, thanks to exceptionally low interest rates, the cost of servicing the nation's debt remains very manageable … for now. Some countries hot, some cold and no Goldilocks Globally, economic growth continues to diverge, with escalating inflation in India prompting the Reserve Bank of India to raise rates intra-meeting, as high food prices can filter through the agriculture-based economy. Farmers' incomes rise with increasing food prices and low-income individuals have a high marginal propensity to consume, increasing the risk of overheating in the Indian economy. However, in Japan deflation remains a problem, and while Bank of Japan policymakers noted balanced risks to the economy in their February meeting minutes, they eased policy in March by extending the three-month loan facility to 20 trillion yen ($222 billion). The problem for Japan is that additional injections of liquidity are doing little to bolster the domestic economy, with weak credit growth and consumer demand. Also troubling is Japan's aging population, which typically results in more-conservative spending trends relative to a young working population. Meanwhile, Australia has remained resilient, avoiding the recession due to its strong economic ties with China and a healthy banking system. The housing market rebounded quickly, posting a modest 6% decline in prices from peak to trough, due to government incentive programs, high affordability and housing shortages. Job growth in Australia returned in September 2009, and a strengthening Aussie dollar has boosted consumers' purchasing power. As such, the central bank has increased rates four times in recent months, and rising interest rates have cooled growth. Like Australia, Canada is benefitting from strength in natural resources and healthy financial institutions. Canada's housing market only experienced a 9% peak-to-trough decline in prices thanks to conservative lending practices, and Canada has also seen job growth. Canada is more US-dependent than Australia, with nearly 75% of exports shipped to the United States. However, domestic consumption trends look stronger than in the United States and the central bank is taking note, referring to inflation risks as balanced in its March statement, instead of being tilted to the downside. Like many nations, including the United States, Canada has a difficult balancing job with the recovery still nascent and subject to higher-than-normal risks and high unemployment. Exports, historically around 40% of GDP, are being constrained by strength in the Canadian dollar, which would likely rise further if a rate hike cycle began. However, emergency conditions have passed, and Canada's central bank will likely want more flexibility to move without the constraints of a conditional commitment, with a current pledge to keep rates on hold until the end of June. Currency trends moving in tandem with divergent economic growth Problems in the eurozone, highlighted by a common currency that hamstrings currencies from naturally adjusting to changes in economic growth, as well as debt concerns in the PIIGS (Portugal, Ireland, Italy, Greece and Spain), have hurt the euro. Meanwhile, in the United Kingdom an elevated deficit, high debt and political wrangling ahead of May elections has hit the pound sterling. Declining confidence in the euro and pound sterling has the US dollar winning the "least ugly" contest among major currencies for now. Currencies moving in tandem with monetary policy  Source: FactSet, Global Insight, as of March 25, 2010. International markets have underperformed the S&P 500 Index in 2010, with performance for US investors in many developed markets hurt by the relative strength of the US dollar. Strong economic growth in many emerging-market and natural-resource nations suggest the need for monetary policy to tighten, hampering local market returns, while relative weakness in the US dollar in these markets has boosted returns when translated back into US dollars. Currency volatility will continue, with the possibility of counter-trend moves, but we expect recent movements to persist in the near term. China remains a source of heated debate Meanwhile, economic growth in China has led the global recovery, but stocks have struggled, as have returns for US investors in China, due to the quasi-peg of the yuan to the dollar. While China has yet to officially raise benchmark interest rates, policymakers have implemented measures intended to slow growth, targeting credit extension and raising reserve requirements. Chinese stock-market performance has been hampered by the implications of slower economic growth as well as mandates from regulators for banks to raise capital in the near future, with some estimates topping $100 billion. Another trend worth noting is the ascent of the US market cap as a percentage of global market cap and the related descent of China's market cap. Chinese shares underperforming  Source: FactSet, Global Insight, Standard & Poor's, as of March 25, 2010. Media attention on the potential for asset bubbles in China continues, and the lack of detail and transparency of data fans the flames. Property markets in China benefitted from speculation in 2009 and prices in some cities rose at elevated rates. However, unlike the housing-market bubble in the United States, Chinese homeowners are required to put down anywhere from 20% to 40%, leaving plenty of equity in homes. Measures implemented by regulators have cooled sales, and prices are likely to follow, but equity levels suggest a lower probability of "forced" sellers if and when prices fall steeply. Protectionism heating up Chinese officials are taking action to slow growth, but remain concerned about the export sector, with near-term growth likely boosted by inventory replenishment in the United States, but still subject to risk with overcapacity in many industries. As such, they've kept the yuan peg to the US dollar and remain resistant to international calls to allow appreciation. While authorities have targeted domestic lending to slow growth, foreign capital can still flow into the country. We believe either the yuan will need to appreciate or capital restrictions implemented to limit credit growth. Media attention on the Chinese currency has grown feverish, with Nobel-prize economist Paul Krugman calling for a 25% across-the-board tariff and members of the US Congress calling on the Treasury Department to label China a "currency manipulator" in a report due April 15. The possibility of a trade war would be damaging to global economic growth and stock markets, as there's typically no "winner"—astute investors recall that protectionism in the name of the Smoot-Hawley Tariff Act was what deepened the Great Depression. While it's likely too early to become bullish, the nearly overwhelming negative view toward the Chinese economy and stock market suggests a situation where sentiment can start to work as a contrarian indicator, setting the stage for possible outperformance. Important Disclosures The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 2005, the MSCI EAFE Index consisted of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 2005, the MSCI Emerging Markets Index consisted of the following 26 emerging market country indexes: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela. The S&P 500® index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly. Past performance is no guarantee of future results. Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks. The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice. (0310-2146) Return to Top |