U.S. markets continue up
November was another very strong month for U.S. stock markets. The Dow Jones Industrial Average was up 3.82 percent, while the S&P 500 and Nasdaq Composite indices experienced returns of 3.05 percent and 3.58 percent, respectively. Gains were broad based, with growth slightly outperforming value and small stocks outperforming large ones. The only domestic equity asset class showing an actual decline was real estate investment trusts (REITs), which underperformed largely due to its exposure to interest rates (see chart).
Figure 1. REITs Underperformed U.S. Stocks in November
Technical factors remained supportive. As markets rose, resistance levels turned into support levels. With all indices well above their 50- and 200-day moving averages, there were no technical red flags.
Fundamentals also showed no major change in trend, with earnings beating expectations overall for the quarter. Valuation levels, though continued to move higher from already extended levels, suggesting that current market prices may be subject to risk.
International market returns were more muted. The MSCI EAFE Index gained 0.77 percent for the month, while the MSCI Emerging Markets Index actually posted a 1.56-percent loss. Europe's economy continued to show slow improvement but did not excite investors, and emerging markets continued to wrestle with the potential for Federal Reserve (Fed) tapering.
Interest rates rose during the month, with the benchmark 10-year Treasury bond increasing from 2.57 percent to 2.75 percent. The rise in rates drove the previously mentioned decline in the MSCI U.S. REIT Index and also sent the Barclays Capital Aggregate Bond Index down 0.37 percent. Investors sought risk within fixed income markets but avoided duration. Treasuries and mortgage-backed securities were losers over the month. Meanwhile, high-yield and bank loans posted modestly positive returns. November's numbers were broadly reflective of the year-to-date trend of spread-oriented securities outperforming duration-sensitive bonds.
Domestic economy still improving
Continuing positive economic news drove the rise in rates and strong U.S. equity market performance. At the start of the month, gross domestic product was reported to have grown 2.8 percent in the third quarter, much higher than the expected 2-percent increase. This surprise was reinforced by improvements in initial unemployment claims, which declined from 336,000 to 316,000 during November.
The outlook for manufacturing businesses also improved. The ISM Manufacturing survey reached a two-and-one-half-year high at the start of November, due to increased business activity, including hiring. Private payrolls increased 212,000, up from 150,000 in October, implying that business confidence had not been damaged by the government shutdown. The jobs situation was also bolstered by higher pay, as the wage growth rate ticked up to 2.2 percent on an annual basis, and personal income increased a substantial 0.5 percent relative to the previous month.
Higher incomes also supported better retail sales, which increased 0.4 percent in October, a strong gain. Because consumption makes up about 70 percent of the economy, consumer spending has a tendency to heavily impact overall economic growth. The current level of spending should be sustainable, given that the growth in sales was actually less than the increase in personal income, and the savings rate rose.
Janet Yellen nominated as new Fed chairperson
As expected, Janet Yellen was nominated to succeed Ben Bernanke as the Fed's chairperson. Financial markets interpreted this as a positive development because Yellen is widely perceived as a "dove" who will likely continue the Fed's existing supportive policies. The reduction in uncertainty as a result of her nomination was also a positive factor, and investors were likely impressed by her strong performance in her confirmation hearing.
Despite the increase in rates during November, it seems likely that rates will remain lower than they would have been had Yellen not been nominated. The possibility of a reduction in the Fed's bond purchasing remains a possibility for December, but it is probably less likely than it was before. Investors appear to expect any taper to be smaller and slower under Yellen than it would have been had she not been appointed.
International economic prospects look better
Europe and China both displayed economic progress during November. European growth was led by strong improvements in the United Kingdom and Germany, but even peripheral markets showed improvement. Ireland and Spain were set to exit their financial support programs, and Greece showed signs of a primary surplus, which caused Moody's to raise the country's credit rating two steps. An outlier was France, which continued to struggle. But the widespread improvements in other eurozone areas suggested that a slow recovery was taking hold.
In China, the big news was the completion of the Third Plenum, in which China's leaders outlined their plans for the years leading up to 2020. Initial media reports implied that the results of the meeting were disappointing. In reality, however, a number of market-friendly reforms were discussed, including deregulation of areas of the economy currently dominated by state-owned enterprises, financial liberalization via the abolition of certificate of deposit rate ceilings, and plans to give equal rights to foreign and domestic equity investors. If these plans are implemented, they should be a boost to longer-term economic performance by prioritizing consumption over investment and increasing the private share of the economy. China's growth statistics, as if on cue, also signaled a rebound.
Markets bright, but clouds ahead
The strong performance of U.S. equity markets in November is encouraging, but worries remain. The first is the relatively high level of stock valuations, based largely on expected continued Fed support. Although ongoing support is probable, the better economic data suggests that it may be more limited than markets expect.
Another concern is the durability of recovery in the rest of the world. The weaker stock market performance abroad suggests that investors around the globe are less optimistic than they are here. A substantial part of our current market performance is based on continued recovery in Europe and growth in China. Both appear likely, but risks remain.
Cautious optimism remains the appropriate stance. 2013 has been a very strong year for the market, and a pullback at some point is inevitable—even healthy. It is important that investors maintain a disciplined program and treat the good times as calmly as they treat the bad ones.
Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research analyst, at Commonwealth Financial Network.