Strong May marred by volatility at the end
May was another strong month for the equity markets, with a total gain of 2.34 percent for the S&P 500 Index, 2.24 percent for the Dow Jones Industrial Average, and 3.82 percent for the Nasdaq. Both the S&P 500 and the Dow notched new all-time highs, but the positive results masked a great deal of intra-month volatility. The first weeks of the month showed almost uninterrupted increases, while the last week was quite volatile, with multiple daily gains and losses of more than 1 percent, in addition to a noteworthy sell-off on the final day of May.
Fundamentals were unchanged for the month, with no new earnings announcements. Valuations crept higher with the market itself, extending further above historical levels on a long-term basis and starting to rise above those levels on a short-term basis. Technicals remained relatively strong despite the month-end turbulence, with all indices well above their 50- and 200-day moving averages.
Equity market volatility was driven largely by comments from Federal Reserve (Fed) Chairman Ben Bernanke, who seemed to suggest in a May 22 appearance before Congress that the Fed might start to reduce its asset bond purchases much sooner than had been anticipated. This unexpected information led investors to reconsider future growth expectations.
Chairman Bernanke's comments also caused volatility in the fixed income markets. The Barclays Capital Aggregate Bond Index lost 1.78 percent for the month, and 10-year U.S. Treasury yields rose from 1.66 percent to 2.16 percent (as referenced in Figure 1). The floating-rate bank loan sector was the only fixed income sector to post positive returns, and long-duration Treasuries and TIPS were hardest hit. International bonds, particularly emerging market debt, also underperformed.
Figure 1: 10-Year U.S. Treasury Yields, January 2013–May 2013
International stock markets significantly underperformed U.S. markets for the month, on both a relative and an absolute basis. Representing developed markets, the MSCI EAFE Index was down 2.41 percent. The MSCI Emerging Markets Index was down even more, losing 2.94 percent. Volatility came largely from Asia. Japan experienced very wide swings, with large gains in the first half of the month erased and turned into losses in the second half. Of the major emerging market stock markets, Brazilian equities in particular struggled, losing 7.11 percent of their value.
The real economy continued to grow
While Wall Street experienced volatility, Main Street appeared to continue its steady recovery. Early in May, employment gains for April came in above expectations, and there were substantial upward revisions for previous months. These positive signals were confirmed during the month, as initial unemployment claims persisted at low levels, close to the lowest numbers since January 2008.
Housing showed strength as well. Both new and existing home sales increased, by 2.3 percent and 0.6 percent, respectively, to the highest levels since mid-2008. In addition, house prices climbed more than 10 percent year-over-year, per the S&P/Case-Shiller 20-City Home Price Index. The supply of houses for sale remained well below normal levels, which is around 6 months, coming in at 4.1 months for new homes and 5.2 months for existing homes. The below-normal supply and persistent strong demand suggest that the home price trend may continue.
Rising house values and stock prices combined to bring overall household wealth levels close to pre-crisis peaks. These factors, together with declining gasoline prices, acted to push consumer confidence up. Both the University of Michigan Consumer Sentiment and Conference Board Consumer Confidence indices came in at or close to five-year highs in May.
At the end of the month, economic growth for the first quarter was revised slightly lower than had been initially estimated, from 2.5 percent to 2.4 percent. Even this downward revision had a positive take, however, as it was mostly due to a larger-than-estimated decline in government spending. Net of that, the private economy actually grew slightly faster than the initial estimate, per Capital Economics.
With so many indicators for the real economy at multiyear highs, and despite the ongoing effects of sequestration, many forecasters expect economic growth to continue at reasonable levels for the rest of 2013.
Growing economy puts Fed on the spot
With the real economy growing and stock markets performing relatively well, the Fed is in a quandary. At some point, it will have to start winding down its stimulus program, which currently buys $85 billion in bonds per month. The question is: When?
When Chairman Bernanke testified on May 22, he said it was quite possible that the Fed would start to slow (and end) its program in the second half of this year, sooner than many had thought. His actual testimony went further than his written preliminary testimony, and this came as a surprise to the financial markets. The prospect of a quicker-than-expected wind-down led to market turmoil, with a drop of more than 2 percent on May 22 and a further decline the next day.
The volatility caused by the chairman's comments highlights one of the major risks for investors in this market—the uncertainty surrounding the continuation of Fed support. Although it does not appear that the Fed intends to exit immediately, at some point it will do so. That exit may result in higher interest rates, which could cause market turbulence and possibly act as a headwind to the ongoing recovery.
Real economy solid, markets less so
At month-end, the real economy appeared well positioned for continued growth at current levels, but financial markets appeared less stable. Much depends on when and how the Fed starts to reduce its stimulus program. Interest rates will be the primary channel. If rates start to tick up significantly, both stock and bond valuations could be at risk.
Right now, however, interest rate increases don't appear likely in the short term, though they are eventually inevitable. Investors should be aware of this and plan for the volatility that may come when the Fed makes its move. At that time, the recovery in the real economy may be more firmly in place, which should, we hope, provide a firm foundation if markets wobble.
For investors, cautious optimism remains the appropriate stance. Improvements in the real economy certainly inspire confidence, yet the end-of-month market instability serves as a reminder for investors to be positioned with long-term goals in mind rather than with the objectives of following short-term trends.
Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network.