Stocks Sell Off, Then Rally Back to Flat
Stocks continued to sell off last week before a Friday rally left them little changed for the week. The Dow Jones Industrial Average was up 0.34% to 16,554, the S&P 500 Index rose 0.19% to 1,931 and the tech-heavy Nasdaq Composite Index inched up 0.12% to end the week at 4,370. Meanwhile, the yield on the 10-year Treasury dropped from 2.50% to 2.41%, as its price correspondingly rose.
The stock market has had a less-than-positive tone the last three weeks, but trading has not been all about risk aversion or getting “defensive.” Instead, relative value seems to be the order of the day, and that is having a big impact on how investors are behaving. We expect this trend to continue.
Good Economic News Tempered by Geopolitical Risks
Global stocks generally lost more ground last week, although U.S. equities managed to stage an impressive rally on Friday and notch a nominal weekly gain. On the positive side, stocks continue to benefit from strong U.S. earnings, with 77% of U.S. companies beating analysts’ expectations and posting surprisingly strong revenue growth of 4.4%. Healthy economic data are also helping. Last week, a key measure of the U.S. service sector reached its highest level since late 2005 while the four-week average of initial unemployment claims fell to an eight-year low.
Unfortunately, however, investors also have to contend with a growing list of geopolitical risks. Last week had no shortage of these: a breakdown of the ceasefire in Gaza, renewed U.S. involvement in Iraq (in the form of air strikes), an escalation of tensions in Ukraine and a set of retaliatory sanctions from Russia.
Rising geopolitical tension is certainly affecting investor behavior. Before retreating on Friday, equity market volatility was close to a four-month high and several so-called “safe haven” assets rallied. For example, despite a slew of strong U.S. economic releases, Treasuries continued to rally with the yield on the 10-year note dropping to a 14-month low. And Treasuries aren’t the only destination for those looking for safety. Investors have also been flocking to German bunds, with yields hitting an all-time low of 1.02%.
Focusing on Relative Value
That said, stocks have not completely followed the typical “risk-off” script. Gold, a classic safe-haven asset, remains well below its spring highs, and certain defensive sectors—notably utilities, telecommunications and health care—have struggled month-to-date.
Meanwhile, a number of higher-risk segments of the market, such as frontier markets and emerging market (EM) stocks in Asia, have performed relatively well. EM Asia has not been immune from the selling, but it has been outperforming the broader market and continues to attract new flows.
This seeming disconnect between investor angst—evidenced by a sideways stock market, rising volatility and selling of high yield bonds—and a proclivity for more exotic markets can be reconciled fairly simply: Investors have a newfound interest in value.
EM Asia is illustrative of this point. This market segment has benefited from stabilization in the Chinese economy and positive election results in India, but there is another reason investors have been attracted to this part of the world: It is relatively cheap. While EM Asia valuations are still above the bargain basement levels seen in 2008, they trade at a 30% discount to developed markets.
In short, at a time when most of the major asset classes look somewhere between fully valued and expensive, investors are being forced to look further afield in search of value and yield. Put differently: In a world where most investments look expensive, reasonable is the new cheap.