This year’s perennially aloft stock market finally took a tumble last week after Fed Chairman Ben Bernanke hinted at tapering the massive bond purchase program (aka QE3) designed to hold down long-term interest rates and stimulate economic growth.  The financial markets reacted violently and sent shudders worldwide.  Some notable statistics:

• Stocks lost about $500 billion in market capitalization or about 2% for the S&P 500[1]
• The VIX index, often referred to as the fear index, rose 23% to 20.49, its highest level since December 2012 (see VIX chart below)
• The bond market lurched with 10-year bond yields jumping to 2.5%, a roughly 17% increase from 2.13% levels a week earlier
• Mortgage lending rates shot up the most in 26 years and now average 4.46% for a 30-year loan, a substantial jump from early May’s 3.35% level or more than a 33% increase)

Not surprisingly too, the shoot-up in rates, which has the potential to derail the entire economy, hit housing stocks and REITs disproportionately hard.

This week: Some back-steps

Clarification by Fed officials this week (notably William Dudley of the New York Federal Reserve) has calmed roiling markets, and the US stock market has still marked double digit returns for 2013 – not bad for six months.  From my perspective, the media’s and pundits’ handwringing obscures the potential positives of Fed speak.

From a positive viewpoint, the Fed is communicating that it stands ready to gradually slow bond purchases so that interest rates normalize when:

1. Unemployment has receded to lower levels
2. The economy is on a self sustaining trajectory

What comes next? A focus on company earnings and what to look for

Next week marks the end of the second quarter and the beginning of company reporting season.  From a stock investors’ perspective, these are the things to look for:

• While revenues are expected to be flat (reflecting slow spending somewhat due to the effects of sequestration muting demand), the focus on expanding margins, productivity and bottom-line profits will be key.  I would also pay attention to company guidance by large bellwether companies. What are the business challenges and opportunities on their minds? 

• The slowdown in China and other parts of the world has lowered the cost of raw materials for large manufacturers.  In addition to the US consumer, who comprises almost 70% of the US economy, my attention is focused on manufacturing.  What are the comments from CEOs of industrial companies regarding their customers, costs, productivity etc.? 

• Sector performance:  So far this year more defensive sectors of the economy have outperformed including Healthcare up almost 20%, Consumer Discretionary up more than 16% , and Technology up more than 12%.  The laggards have been Materials down almost 9%, Energy up 1% and Utilities at 7%.  For the last quarter, leadership has stayed somewhat the same but with Financials being in the top three leaders (along with Health Care and Consumer Discretionary.)  I would pay attention to any upcoming changes in sector leadership.

More about earnings…

Check back for more commentary about sector performance as the earning seasons progresses.  www.thehuffmanbroadsheet.com will keep you posted on important topics to consider for your investing going forward.

Mid cap stocks have outperformed versus small and large cap benchmark indices

Although mid cap stocks are sometimes overlooked in the asset allocation discussion of how much to invest in stocks, bonds and alternative investments, they can be a meaningful contributor to portfolio returns and diversification.  The chart above shows that the outperformance by the Standard & Poor’s Midcap index compared to both the Standard and Poor’s 500 and Russell 3000, both indices of the largest companies, since 1995.  Annual average return for S&P’s Mid cap index was over 4% greater than the large companies.  Why?

First, a definition of mid cap stocks

Mid caps are less easy to define than small or large capitalization stocks – by their very nature of being in the middle.  Small cap companies tend to be defined as those valued at less than $1-3 billion (depending on the index family).  And, large cap companies tend to be well known – think of Exxon, Apple, IBM etc. –  and measured in the hundreds of billions.

In contrast, mid cap stocks may be defined as high as $15 billion depending on the mutual fund manager. Benchmark families may also define mid cap stocks differently. S&P defines mid caps as the 400 companies with market value between $1-4.4 billion.  Russell goes as high as $8 billion.

Why do mid caps outperform?

Regardless of the exact parameters of middle-sized companies on the capitalization scale, the long-term outperformance is clear.  One strategist I know prefers mid caps, describing them as small caps on their way to becoming large caps, with a stopover in the mid cap range during their high-growth phase (Note: companies, large or small can also be fast growers but mid caps seem to capture the high-growth stage more demonstrably.)  Mid caps tend to be more established – read older – than small cap companies with more experienced management teams.  Mid caps may also be attractive as acquisitions to large companies looking for growth.   And in a period where US companies are outperforming many parts of the world economy, mid caps tend have a greater proportion of domestic earnings than large multinational companies.

Your stock allocation

Mid cap stocks represent less than 10% of the equity market in terms of value.  They are a good way to increase the equity diversification in a portfolio along with large and small cap stocks.  Adding mid caps increases the breadth of equity exposure in a well-diversified portfolio.  Just like the middle child, do not overlook your mid caps.

Last October, I predicted that housing could to be a driver for all sorts of good things in the economy.  [See “Will Housing Provide the Growth we are looking for?“] With Case-Shiller’s latest report showing house prices advancing a robust 10.9% year over year (compared to the same period a year ago), it is clear that residential housing prices overall have rebounded from recessionary lows. See graph.

Home prices are still below their 2006 peak but have recovered to 2003 levels

Source:  Bloomberg, May 28th, 2013

As has oft been written, a rebound in housing is a positive development for many reasons.  When house prices increase, the wealth effect kicks in.  Investors feel wealthier and they spend more, which in turn causes a ripple effect (also know as a multiplier effect).  Positive related effects range from expanded balance sheets for banks, increased furniture sales for retailers, greater demand for employees at companies supplying residential goods and services etc.

In tandem with better-than-expected housing data, consumer confidence data also showed a surprisingly positive increase to 76.1, which is almost 12% higher than the previous month as reported by Bloomberg on Tuesday.  Current GDP data confirm a housing rebound and steady overall growth despite a decrease in government expenditures due to sequestration.[1]

Looking to the market: Top performing industry groups confirm broader economic healing

This year, the top performing industry groups in the stock market show greater diversification compared to 2012.  As shown in the table below, housing related stocks were the top performers taking four out of the top ten slots – no surprise there (see table below).

With 2013, some of the newcomers include Toys, Electronic Office Equipment, Business Training, Travel and Tourism, Specialty Retailers, and Asset Managers.  Increased employment and higher confidence are giving consumers the wherewithal to spend again on discretionary items. And in the stock market, confidence is reflected in the retail investor’s willingness to rotate into stocks.

Source:  Barron’s May 22, 2013

Animal Spirits – What next for the market?

Consumer confidence is now the highest it has been since prerecession crises.  Consumers have spent the last few years deleveraging and paying down debt.  We are now seeing the fruits of that spending discipline – along with Federal Reserve policies to stimulate economy via low interest rates – reflected in the markets as well as the broader economy.   With the rebound in housing, improving employment and gross domestic product, “Animal Spirits” are here.