U.S. Equities Face Strong Headwinds After Good Quarter


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U.S. equity markets in the third quarter generally reacted positively to Federal Reserve stimulus plans and the outlook for continued low interest rates, but there are "possibly strong headwinds" coming in the months ahead, CME Group analysts said in a report.

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U.S. Equities Face Strong Headwinds After Good Quarter

  1. 1. STOCK INDEXESEquity Market Monitor3rd Quarter2012OCTOBER 11, 2012John W. Labuszewski John E. Nyhoff Richard CoManaging Director Executive Director Executive DirectorResearch & Product Development Research & Product Development Equity Products312-466-7469 312-930-2310 312-930-3227jlab@cmegroup.com john.nyhoff@cmegroup.com richard.co@cmegroup.com
  2. 2. The price performance of the domestic equity 29th. 2 Similarly, the DJIA posted a total return ofmarket is generally measured by reference to stock +5.00% during the 3rd quarter for a year-to-dateindexes that aggregate the performance of multiple advance of +16.45%. Meanwhile, the Nasdaq-100stocks. CME Group offers liquid futures contracts generated a total return of +7.35% for the quartertied to a wide variety of frequently referenced and +23.93% for the year. (See “Summary Data”“benchmark” stock indexes including the Standard & table below.)Poor’s 500 (S&P 500), the Dow Jones IndustrialAverage (DJIA), the Nasdaq-100 and many more. S&P 500 Index & VIX 1,600 90% 1,500 80%Many fundamental factors, including general 1,400 70%macroeconomic conditions, Fed monetary policy, 1,300fiscal policy, foreign investment interest, to name 60% S&P 500 1,200just a few, impact the price performance of these 50% VIX 1,100stock indexes. This document provides a review of 40% 1,000these factors as they played out in the most recently 30% 900completed calendar quarter. While we cover activity 800 20%in a broad spectrum of domestic stock indexes, the 700 10%S&P 500 represents a central focus of this 600 0%discussion. Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12Stock Price Action S&P 500 VIXOver the past decade, the domestic equity markets Similarly, the DJIA posted a total return of +5.00%have fluctuated up and down within a very broad during the 3rd quarter for a year-to-date advance oftrading range. This range has been defined by the +16.45%. Meanwhile, the Nasdaq-100 generated adepths plumbed in the wake of the “dot-com” crisis total return of +7.35% for the quarter and +23.93%and subsequent “sub-prime mortgage crisis” – with for the year. (See “Summary Data” table below.)highs put in just prior to the point where thosesituations broke in 2000 and in 2008, respectively. Fundamental FactorsBut as of the conclusion of the 3rd quarter 2012, Domestic equity market action during the 3rd quarterdomestic equity markets, as measured by the S&P 2012 was colored by a number of fundamental news500, have gravitated towards the upper reaches of events including the ongoing European sovereignthat long-term trading range. The S&P 500 closed debt crisis. While European sovereign debt woesat 1,440.67 as of September 28th and up from its remain far from resolved, the markets nonethelessvalue of 1,362.16 as of the conclusion of the 2nd took considerable comfort from the Europeanquarter 2012. This resulted in a 3rd quarter total Central Bank (ECB) offer of September 6th to buyreturn of +6.33%. 1 On a year-to-date (YTD) basis the debt of troubled Eurozone nations.through the 3rd quarter, the S&P 500 has gained+16.45% on a total return basis.Meanwhile, the S&P 500 Volatility Index (VIX) haswound its way down to 15.73% by September 28st 2 Note that there is a consistent inverse relationshipand off from the value of 17.08% seen as of June between equity values and the VIX. This may be explained by the observation that equities often break swiftly and suddenly as investors seek to liquidate positions quickly in response to troublesome economic news. Thus, volatilities tend to advance in bear markets. On the other hand, equities tend to rally slowly and steadily. The steady influx of funds into the equity1 The total return associated with an index represents the markets as a result of retirement programs, combination of the return attributed to price fluctuations implemented with automated payroll contributions, such as well as the accumulation of dividend income. Thus, as 401Ks contributes to this effect. Thus, equity the total return associated with an index will generally markets tend to exhibit declining volatilities in bull exceed the price return. markets.1 | Equity Market Monitor 3rd Quarter 2012 | October 11, 2012 | © CME GROUP
  3. 3. Taking a cue perhaps from the Fed’s quantitative Thus, the “Labor Force Participation Rate” haseasing (QE) programs, ECB President Mario Draghi become of increasing interest over the past fewunveiled an open-ended plan to buy securities going years. Note that while the unemployment rate hasout up to 3 years in maturity. This offer is declined from its peak of 10.0% in October 2009,conditioned upon the receipt of a formal application the Labor Force Participation rate has steadilyfor such aid along with adoption of fiscal austerity declined to 63.6% by September 2012.measures. Employment StatisticsThe situation in Europe was further calmed by a 11% 67%ruling by Germany’s constitutional court on 10% 67% Labor Force ParticipationSeptember 12th that endorsed a 500 billion EUR Unemployment Rate 66% 9%bailout fund known as the European Stability 66%Mechanism (ESM). The ESM would require Eurozone 8% 65%states to contribute 32 billion Euros in two tranches 7%by the conclusion of October. 65% 6% 64%These events lent strength to the Euro and to equity 5% 64%markets around the globe. Still pending, however, 4% 63%are decisions on a possible bailout package for Spain Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12and the disposition of the 240 billion EUR Greekbailout package. These issues likely will not bedetermined until a summit of European leaders Unemployment Rate Labor Force Partcipation Source: Bureau of Labor Statistics (BLS)scheduled for late October. This statistic is hovering near the lowest rateOn the domestic front, 2nd quarter 2012 GDP was recorded since September 1981 and reflects largemost recently reported at a rather anemic +1.3% numbers of long-term unemployed simply droppingand quite a bit lower than preliminary reports of out of the workforce entirely. We might conclude+1.8% growth. This further represents substantial that the decline in the unemployment rate since latedecline from 1st quarter growth reported at +2.0%. 2009 is largely attributable to frustrated workers and not to any true economic recovery. Growth and Employment 6% 11% 4% 10% As a result, the Fed announced on September 13, Qtrly Change in GDP Unemployment Rate 2% 9% 2012 that it would “increase policy accommodation 0% by purchasing additional agency mortgage-backed 8% -2% securities at a pace of $40 billion per month … [it] 7% -4% also will continue through the end of year its 6% -6% program to extend the average maturity of its -8% 5% holdings of securities … These actions, which -10% 4% together will increase the Committee’s holdings of longer-term securities by about $85 billion each Q1 04 Q4 04 Q3 05 Q2 06 Q1 07 Q4 07 Q3 08 Q2 09 Q1 10 Q4 10 Q3 11 Q2 12 month … should put downward pressure on longer- Seasonally Adj Real GDP Unemployment Rate term interest rates … [and] … support mortgage Source: Bureau of Economic Analysis (BEA) markets.” 3 & Bureau of Labor Statistics (BLS) In other words, the Fed is initiating another round ofThe unemployment rate, which has been trending quantitative easing (“QE3”), focusing on the anemicdown in recent months, was reported at 7.8% by housing sector. Unlike previous QE programs, QE3September 2012. As cheery as that numberappears, it may be quite misleading as it does notreflect the declining proportion of the population that 3is actually employed. Federal Reserve Press Release dated September 13, 2012.2 | Equity Market Monitor 3rd Quarter 2012 | October 11, 2012 | © CME GROUP
  4. 4. is open-ended with no pre-determined total package Consumer Price Index (CPI)size. Further, the Fed is continuing its “Operation 6%Twist” originally announced in September 2011. But 5% Year-on-Year Change 4%this time, the program is aimed squarely at the 3%mortgage markets. 2% 1%While housing market activity remains at levels of 0%roughly 1/3rd of peak activity observed in late 2005, -1%there are actually some signs of life in the market. -2%Building permits were reported above 800 thousand -3%units in July and August for the first time since Mar-05 May-06 Sep-08 Apr-09 Mar-12 Nov-09 Aug-04 Jun-10 Aug-11 Jan-04 Oct-05 Dec-06 Jul-07 Feb-08 Jan-11August 2008. Home values, while still well belowpre-crisis peaks, have been recovering a bit in mostmarkets across the nation. Certainly this renewed CPI - All Urban Consumers SA CPI ex-Food & Energyactivity may be attributed in some part to continued Source: Bureau of Labor Statistics (BLS)record low mortgage rates. Equity markets generally reacted quite positively to Housing Activity the prospects of continued low interest rates as 2,500 suggested by the Fed. Still, the marketplace faces 2,000 some possibly strong headwinds in the form of possibly disappointing corporate earnings reported 000 Units 1,500 in October; domestic political uncertainty with elections looming in November; the impending 1,000 “fiscal cliff;” possible delays in European bailout 500 packages; and, continuing emerging market economic deceleration in economies notably 0 including China. Sep-03 May-04 Sep-05 May-06 Sep-07 May-08 Sep-09 May-10 Sep-11 May-12 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 U.S. Corporate Profitability 120% $1,800 Building Permits Housing Starts Completions 100% Pre-Tax Profits (Billions) Source: Dept. of Housing & Urban Development (HUD) $1,600 Annualized % Change 80% 60% $1,400The Fed further decided “to keep the target range 40%for the federal funds rate at 0 to ¼ percent and $1,200 20%currently anticipates that exceptionally low levels for 0% $1,000the federal funds rate are likely to be warranted at -20%least through mid-2015.” 4 $800 -40% -60% $600This latest Fed policy announcement has been Q1 04 Q4 04 Q3 05 Q2 06 Q1 07 Q4 07 Q3 08 Q2 09 Q1 10 Q4 10 Q3 11 Q2 12criticized by some as inflationary in the long-termdespite the Fed’s observation that “longer-term Annual Change Corporate Profits (Bil)inflation expectations have remained stable.” 5 Infact, August reports show the Consumer Price Index(CPI) advancing +1.70% on a year-on-year basis Corporate Profitabilitywith CPI ex-food and energy at +1.90% - and wellwithin the Fed’s mandate. On a more granular basis, we note that price performance is driven generally by corporate profitability. Corporate profitability has closely followed macroeconomic conditions such as GDP. As such, profitability plummeted during the height of4 Ibid. the subprime mortgage crisis from 2007-2009.5 Ibid.3 | Equity Market Monitor 3rd Quarter 2012 | October 11, 2012 | © CME GROUP
  5. 5. This, in turn, weighed on the value of domestic lows across most sectors of the yield curve. Theequities. current low interest rate environment is, of course, a function of Fed monetary policy in the wake of theHowever, corporate profits have recovered from the subprime mortgage crisis. Thus, many investorssharp break experienced in the wake of the sub- have focused on equity dividends to the extent thatprime mortgage crisis. During the 2nd quarter 2012, they have become very competitive with fixedpre-tax corporate profits were recorded at $1,664.9 income instruments.trillion, represent a new high and exceeding theprevious all-time high of $1.501 trillion recorded in Dividend & Treasury Yields 5.5%the 4th calendar quarter of 2011 by a healthy 5.0%margin. 4.5% 4.0%Sector Performance 3.5% 3.0%Breaking the S&P 500 into its major sectors, we find 2.5%that energy stocks led the way, advancing some 2.0%+11.16% during the 3rd quarter 2012. The energy 1.5%sector was followed by technology stocks (+7.71%); 1.0%consumer discretionary issues (+7.47%); and, Aug-11 Jun-07 Apr-08 Sep-08 May-10 Mar-11 Jun-12 Jan-07 Nov-07 Feb-09 Jul-09 Dec-09 Oct-10 Jan-12financials (+6.95%). The worst performing sectorduring the 3rd quarter were utility stocks (-0.49%),followed by industrials (+3.25%); consumer staples Dividend Yield 10-Yr Treasury Yield(+3.87%); and, materials (+4.96%). A closely watched indicator of dividend value is a S&P 500 Sector Indexes 1,300 comparison of the dividend yield associated with the S&P 500 vs. the yield-to-maturity (YTM) of 10-year Dec. 31, 2011 = 1,000.00 1,250 1,200 U.S. Treasury notes. Current dividend yields for the 1,150 S&P 500 of 2.12% are now significantly above the 1,100 rates associated with 10-year U.S. Treasury notes at 1,050 1.65%. 1,000 950 These extraordinary weak long-term rates are driven 900 by “safe haven” investing in light of the ongoing 850 European debt crisis and weakness in the emerging markets. Fed monetary policy, as described above, 12/30/11 1/20/12 2/10/12 3/2/12 3/23/12 4/13/12 5/4/12 5/25/12 6/15/12 7/6/12 7/27/12 8/17/12 9/7/12 9/28/12 has further weakened domestic interest rates. IXY IXR IXE IXM IXV IXI IXB IXT IXU As such, equity investment has become more competitive relative to fixed income investments.Dividends This situation helps attract investment to the equity sector at the expense of fixed income markets,It has become chic to pay close attention to buoying stocks to a certain extent.corporate dividend policies in recent years. Thisfocus represents a central tenet of the “fundamental Value Investingindexing” movement that attempts to distinguishinvestment opportunity on the basis of a relatively Many investors trade on the basis of trends. Butnarrow number of broad fundamental indicators of many others adopt a somewhat more “counter-corporate value, including dividend policies. cyclical” approach by paying close attention toDividends have further become a major focus of the equity values. The most common reference forequity trading community to the extent that interest equity values is found in the price to earnings or P/Erates have fallen to all-time or at least generational ratio.4 | Equity Market Monitor 3rd Quarter 2012 | October 11, 2012 | © CME GROUP
  6. 6. P/E ratios are most heavily influenced by equity heading for the exits in response to significantprice action. Consider that the S&P 500 P/E ratio fell market breaks.to near 10 as equities retreated at the height of thesubprime mortgage crisis. The subsequent rebound These factors are reflected in an inspection of flow ofin P/E ratios to near 24 was driven by aggressive fund data for equity mutual funds. Equity marketseasing, liberal fiscal stimulus and the prospects of generally performed admirably during the 1st quartereconomic recovery. of 2012 as the S&P 500 generated a total return of 12.56%, inclusive of price performance plus S&P 500 Dividend Yield & P/E Ratio dividend income. This served to stem the outward 4.0% 26 flow of investment from domestic equity mutual 24 funds that had been experienced throughout the 3.5% 22 lackluster year of 2011, based upon data published P/E Ratio Dividend Yield 20 by the Investment Company Institute (ICI). 3.0% 18 16 Equity Mutual Fund Net Cash Flows 2.5% 14 (Billions USD) $20 2.0% 12 $10 10 1.5% 8 $0 Apr-08 May-10 Mar-11 Aug-11 Jan-07 Oct-10 Feb-09 Jan-12 Jun-07 Sep-08 Jun-12 Nov-07 Jul-09 Dec-09 -$10 -$20 Dividend Yield P/E Ratio -$30 -$40Subsequently, P/E ratios retreated on equity Mar-11 May-11 Sep-11 Mar-12 May-12 Nov-11 Jan-11 Jul-11 Jan-12 Jul-12weakness in response to a variety of exogenousshocks including the Japanese earthquake andtsunami, the U.S. fiscal debate and ongoing Domestic Equities Foreign EquitiesEuropean debt crisis. Source: Investment Company Institute (ICI)As of the end of the 3rd quarter 2012, the S&P 500 Conditions weakened during the 2nd quarter as theP/E ratio was measured at 14.67 and up from the total return of the S&P 500 was down -2.76%.figure of 13.75 observed as of the end of the 2nd Thus, the flow of funds reversed downward. The 3rdquarter. This advance over the past quarter brings quarter saw a nice rebound in the equity marketsthe number close to historic standards which with the S&P 500 advancing +6.33%.suggest that the ratio might “normally” be peggedaround 15. This had the effect of decelerating the outflow in mutual funds. More current weekly data from theFlow of Funds ICI suggest that the deceleration in equity fund outflows continued through the course of the 3rdFinally, we may examine the inflow and outflow of quarter. However, it had not reversed into netequity market investments. This investment may be inflows by the final weeks of September 2012.sourced domestically or from overseas marketparticipants. Another interesting source of flow of funds data may be found in the U.S. Treasury Department’sActually, we find these indicators to be somewhat Treasury International Capital (or “TIC”) database.less than revealing to the extent that they are This database tracks flows into and out of the U.S.closely correlated with price action. Certainly, retail The data is broken into foreign stocks, foreigninvestors are known to “chase” the market by bonds, U.S. stocks, U.S. corporate bonds, U.S.buying in response to a bull trend. Likewise, they government agencies and U.S. Treasuries.are often known to exhibit a “herd mentality” by5 | Equity Market Monitor 3rd Quarter 2012 | October 11, 2012 | © CME GROUP
  7. 7. Net US/Foreign Capital Flows was stemmed during the period January through (Billions USD) July 2012 as foreign investors put some $23.1 billion $1,200 $1,000 into domestic equities on a net basis. But this figure $800 paled relative to the $297.7 billion net foreign $600 investment in U.S. Treasuries during the same $400 period. $200 $0 Conclusion -$200 -$400 CME Group offers a broad array of domestic stock -$600 index futures contracts that correspond to each of -$800 the indexes listed in our table below. These 2003 2004 2005 2006 2007 2008 2009 2010 2011 H1 12 products provide facile and liquid vehicles with which one may express a view on prospective market US Treasuries US Govt Agencies US Corporates US Stocks Foreign Bonds Foreign Stocks movements. Or, to manage the risks associated Source: U.S. Treasury TIC Database with holding an equity portfolio in turbulent times.Foreign investors liquidated some $573.6 billion inU.S. equities during 2011 while investing some$380.6 billion in U.S. Treasuries. By the outflow6 | Equity Market Monitor 3rd Quarter 2012 | October 11, 2012 | © CME GROUP
  8. 8. Summary Data (9/28/12) Price Price Ticker Total Total Index Appre- Appre- Dividend P/E Index (Bloom- Return Return Level ciation ciation Yield Ratio berg) (Q3 ‘12) YTD ‘12 (Q3 ‘12) YTD ‘12 Domestic Macro Indexes Standard & Poor’s 500 SPX 1,440.67 6.33% 5.76% 16.45% 14.56% 2.12% 14.67 Dow Jones Industrial Average INDU 13,437.13 5.00% 4.32% 12.19% 9.98% 2.58% 13.19 Nasdaq-100 NDX 2,799.19 7.35% 7.01% 23.93% 22.89% 1.14% 16.78 S&P MidCap 400 MID 989.02 5.44% 5.03% 13.77% 12.50% 1.49% 18.22 S&P SmallCap 600 SML 468.00 5.40% 5.06% 13.80% 12.75% 1.40% 21.43 S&P 500/Growth SGX 781.52 6.40% 5.87% 17.00% 15.33% 1.82% 16.05 S&P 500/Value SVX 651.44 6.30% 5.63% 15.78% 13.64% 2.48% 13.29 S&P Select Sector Indexes Consumer Discretionary IXY 469.38 7.47% 7.07% 21.38% 19.99% 1.56% 17.86 Consumer Staples IXR 358.20 3.87% 3.12% 12.68% 10.23% 2.86% 17.36 Energy IXE 737.23 11.16% 10.59% 7.82% 6.26% 1.92% 12.07 Financial IXM 155.72 6.95% 6.44% 21.62% 19.89% 1.92% 12.94 Health Care IXV 403.01 6.12% 5.53% 17.70% 15.69% 2.09% 14.18 Industrial IXI 365.63 3.25% 2.63% 10.09% 8.16% 2.39% 13.48 Materials IXB 387.82 4.96% 4.33% 11.63% 9.71% 2.38% 14.56 Technology IXT 309.30 7.71% 7.18% 22.62% 21.02% 1.68% 16.35 Utilities IXU 368.01 -0.49% -1.50% 4.31% 1.09% 4.16% 14.66Copyright 2012 CME Group All Rights Reserved. Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only apercentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that theycan afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All examples inthis brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience.”Swaps trading is not suitable for all investors, involves the risk of loss and should only be undertaken by investors who are ECPs within the meaning of section 1(a)12 of the CommodityExchange Act. Swaps are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited fora swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one tradebecause they cannot expect to profit on every trade.CME Group is a trademark of CME Group Inc. The Globe logo, E-mini, Globex, CME and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. Chicago Board ofTrade is a trademark of the Board of Trade of the City of Chicago, Inc. NYMEX is a trademark of the New York Mercantile Exchange, Inc.The information within this document has been compiled by CME Group for general purposes only and has not taken into account the specific situations of any recipients of the information.CME Group assumes no responsibility for any errors or omissions. Additionally, all examples contained herein are hypothetical situations, used for explanation purposes only, and should notbe considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME,NYMEX and CBOT rules. Current CME/CBOT/NYMEX rules should be consulted in all cases before taking any action.7 | Equity Market Monitor 3rd Quarter 2012 | October 11, 2012 | © CME GROUP