Stocks sold off on the last day of the month but still managed to finish higher in May with the large-cap S&P 500 index up 2.2% and the small-cap Russell 2000 up 4.0%. International stocks finished the month lower with the MSCI EAFE index down -2.9%. Bond prices came under significant pressure as yields rose after Fed Chairman Ben Bernanke hinted that Quantitative Easing may be tapered off sooner than the market expected. The 10-Year US Treasury Yield rose sharply to end the month at 2.16%.
First Quarter US GDP growth was revised lower to 2.4% from the initial estimate of 2.5%. Governments spent less than originally estimated, especially at the county and city level, while consumers spent more than previously thought. After-tax corporate profits declined at an annual rate of 1.9% during the quarter for the first time in a year.
Since March of 2009, most of the stock market rally mirrored the growth in corporate earnings. In 2013 we have also begun to see expansion of the market P/E multiple. This could be a reflection of greater confidence that the economic rally is becoming self-sustaining or a result of unprecedented liquidity fueled by the Fed or a reflection of the relative unattractiveness of alternatives. Most likely it is a combination of these factors and others, but the upshot is that stock market risk increases as P/E multiples go higher unless economic growth accelerates to support higher valuations.
After a strong bull run and a rocky month of trading, the Japanese Nikkei index finished the month lower for the first time in the past 9 months. Despite efforts of the Bank of Japan to stimulate their economy through a weakening of the Yen, the Yen rose sharply late in the month. This is probably temporary and the Yen will likely continue to decline relative to the dollar and other currencies for a while longer. Even though economic weakness is continuing in Europe, investors are beginning to look past the weakness to more attractive valuations, giving some support to European stocks this month.
The market was jolted by Ben Bernanke’s comments about tapering QE, however, it is more likely that the Fed will not lead the market on normalizing policy and will instead be behind the curve when it comes to removing stimulus. Bernanke has warned on many occasions that being too early would be counterproductive to his efforts. His comments this month were probably more about reassuring inflation hawks that QE will not go on forever.
While stocks have moved significantly higher this year and valuations have begun to stretch, the backdrop for stocks still looks relatively favorable, especially if the economy continues to expand in the second half of the year as expected. European stocks are attractively valued on a historical basis but need better economic conditions to emerge. If bond yields creep much higher, they may attract some of the yield-hungry investors that are getting nervous about stocks. Market volatility is always a reminder that diversification can take some of the risk out of your portfolio and help you sleep better at night.
Have a safe and enjoyable summer!
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