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NA Equity Strategy Q1 14

NA Equity Strategy Q1 14

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Published by dpbasic
Ryan Lewenza's Quarterly North American Equity Strategy Report Q2/2014
Ryan Lewenza's Quarterly North American Equity Strategy Report Q2/2014

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Published by: dpbasic on Apr 14, 2014
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04/15/2014

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Report prepared by:
Ryan Lewenza, CFA, CMT North American Equity Strategist
2014 Year-End Forecast
Index EPS P/E Price
S&P 500 Index $115.50 17.0 1,960 S&P/TSX Composite Index $875 16.7 14,650
 
Sector Recommendations
Sector U.S. Canada Preference
Financials Over Over U.S. Consumer Discretionary Under Market Canada Industrials Over Over U.S. Information Technology Over Over U.S. Energy Market Over
 Canada Materials Under Under Canada Health Care Over Under
 U.S. Consumer Staples Market Market Canada Utilities Under Under Canada Telecom Services Under Under Canada
Source: Portfolio Advice & Investment Research Over=Overweight Under=Underweight Market=Marketweight
 = Upgrade
 = Downgrade
This Document is for distribution to Canadian clients only. Please refer to Appendix A of this report for important disclosure information.
Q2/14 Equity Market Update
Highlights
 
North American equities were up in Q1/14, led by the Canadian market. The S&P/TSX Composite Index (S&P/TSX) posted a gain of 5.2%, while the S&P 500 Index (S&P 500) advanced a more modest 1.3%. From a style perspective, small caps underperformed in the U.S. (outperformed in Canada), while value trumped growth.
 
We are upgrading the Canadian energy sector to overweight. Our constructive outlook for the energy sector has led to an increase in our year-end price target for the S&P/TSX to 14,650, from 14,250. Our S&P 500 price target remains unchanged at 1,960.
 
Most leading economic indicators we track are pointing to a recovery in economic momentum and growth in the coming quarters. Key areas of the U.S. economy continue to improve, supporting TD Economics
 forecast for GDP growth of 2.7% in
2014, up from 1.9% in 2013. Canada’s economy should benefit
from the improving U.S. economy, but the slowdown in China is likely to weigh on our heavy resource-based economy.
 
Valuations for the North American equity markets have expanded markedly since the 2009 market lows, and are now at premiums to their long-term averages. Despite this, we continue to forecast additional gains for 2014, driven by improving corporate earnings.
 
The technical outlook for the North American equity markets remains positive. The S&P 500 is in a long-term uptrend and above its rising 50-week moving average (MA). The S&P/TSX broke above an importance resistance level of 12,900 in Q4/13, and is above key MAs. However, it is now trading at stiff resistance at 14,300, and we believe commodity prices will need to trend higher for the S&P/TSX to break above this level.
 
We maintain a cyclical bias, preferring the industrials, financials and information technology sectors. These sectors stand to benefit from an improving global economy, rising interest rates, and our expectations for a ramp up in corporate spending in the coming quarters. We are increasing our cyclical stance in Canada by upgrading the energy sector to overweight, and downgrading the health care sector to underweight.  April 14, 2014
 
 North American Equity Strategy April 14 , 2014 Page 2
Indices Q1 Return 2013 Return
S&P 500 1.3% 29.6%Dow Jones Industrials -0.7% 26.5%Small Cap (Russell 2000) 0.8% 37.0%Growth (Russell 1000) 0.7% 31.2%Value (Russell 1000) 2.4% 29.4%S&P/TSX Composite 5.2% 9.6%S&P/TSX Small Cap 7.1% 4.4%
Q1 Sector PerformanceU.S. (S&P 500)Canada (S&P/TSX)
Financials 2.2% 1.9%Consumer Discretionary -3.2% 3.7%Industrials -0.4% 1.8%Information Technology 1.9% 5.6%Energy 0.2% 8.7%Materials 2.3% 9.2%Health Care 5.4% 12.6%Consumer Staples -0.2% 6.9%Utilities 9.0% 7.5%Telecom Services -0.7% 3.0%
Q2/14 Equity Market Update
North American equities were up in the first quarter, led by the Canadian market. The S&P/TSX posted an impressive gain of 5.2%, while the S&P 500 advanced a more modest 1.3% (Exhibit 1). From a style perspective, small caps underperformed in the U.S. (outperformed in Canada), while value trumped growth in the quarter. In recent weeks, there has been a notable rotation from high growth momentum stocks into value stocks such as U.S. large-cap technology and Canadian energy shares. Given our expectations for improving economic growth, and interest rates to slowly move higher in the coming months, we believe value could continue to outperform growth. This is one factor in our decision to upgrade the Canadian energy sector to overweight. Our more constructive outlook for the energy sector (26% weight in the S&PT/TSX) has led to an increase in our year-end price target for the S&P/TSX to 14,650, from 14,250. Our S&P 500 price target remains unchanged at 1,960. On a sector basis, defensive sectors generally outperformed the cyclical sectors in Q1/14, with utilities, up 9% in the U.S. and 7.5% in Canada, followed by strong performance in the health care sector, up 5.4% in the U.S. and 12.6% in Canada. The U.S. consumer discretionary sector underperformed the most this past quarter, down 3.2%, while the industrials were the weakest in Canada advancing 1.8%. The telecommunications services and financials sectors also underperformed in the quarter.
Remaining bullish but see potential weakness in the summer/fall period
We believe the North American equity markets will be higher by year-end, and continue to forecast high single-digit total returns for 2014. This view is predicated on our expectations for: 1) economic growth to improve following a weather-induced slowdown; 2) improved corporate earnings growth, following an anticipated challenging Q1/14 earnings season; 3) the Federal Reserve (Fed) to leave the federal funds rate unchanged until the spring/summer of 2015. Additionally, equity valuations, while above their long-term averages, are not at levels typically associated with major market tops. That said, the North American equity markets could encounter some headwinds in the second or third quarter of 2014, which we would view as a buying opportunity. First, the weak seasonal period of May to September is quickly approaching (Exhibit 2). Since 1990, the May through September period has returned on average -0.17%, versus 8.20% for the October to April period. Moreover, in years with a U.S. mid-term election, the summer has historically been even weaker, declining 2.5% on average in Q2, mainly driven by poor performance in June. Finally, while we expect the Fed to keep interest rates unchanged until next year, equity markets will likely begin to price in a 2015 rate increase sometime in H2/14. Historically, the S&P 500 has typically pulled back an average of 6.5% in the six-months preceding the first federal funds rate hike. Therefore, with weak seasonality approaching, and the equity markets likely to price in a federal funds rate hike in H2/14, we expect increased volatility over the next quarter or two. However, this is likely to provide another buying opportunity, within the context of the cyclical bull market.
Exhibit 2: S&P 500 is approaching weak seasonal period; S&P 500 typically declines 6.5% before first Fed hike
0.28%-0.08%1.44%1.72%0.98%-0.56%0.77%-1.01%-0.34%1.48% 1.43%1.93%
-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
S&P 500 Monthly Price Return
 
 
Exhibit 1: Q1/14 Price Returns
Source: Bloomberg Finance L.P. As of April 1, 2014 Source: Bloomberg Finance L.P. As of April 1, 2014 Period is 1990 to current based on monthly return data Source: Bloomberg Finance L.P. As of April 1, 2014
Date of FirstFed Hike6 Months Before6 Months After
2-May-83 -7.5% -6.9%16-Dec-86 -9.5% -9.3%4-Feb-94 -2.7% -6.8%30-Jun-99 -7.1% -9.9%30-Jun-04 -5.6% -6.5%
Average-6.5%-7.9%Max correction
 
 North American Equity Strategy April 14 , 2014 Page 3
Economic Update
 As North America emerges from the deep freeze experienced over the winter, we expect economic momentum to improve following the weather-induced Q1/14 slowdown. According to the U.S. National Weather Service, the December to February period was the coldest in 20 years. From record high flight cancelations to
the Fed’s Beige Book update, which
mentioned weather 119 times, the severe winter weather impacted consumer spending and economic activity in recent months. Coincident with rising temperatures, we believe more recent economic releases are beginning to capture the improving economic momentum. U.S. light vehicle sales rebounded sharply in March, following a marked slowdown in the December to February period. In March, vehicle sales rose to 16.3 million units annualized, up from
February’s
 disappointing 15.3 million units, and the highest level since February 2007 (Exhibit 3). Recent manufacturing data has also shown improved strength, with the Philadelphia Federal Manufacturing Index (Philly Fed) bouncing back to 9 in March, from -6.3 in February and the national ISM Manufacturing Index (ISM) rising 0.5 to 53.7 in March. Given the Philly Fed Index typically troughs before other regional manufacturing indices, and the ISM manufacturing new orders sub-index remains strong, we believe the U.S. manufacturing sector is approaching an inflection point, and should improve in the coming months. Finally, on the employment front, initial jobless claims recently declined to new cycle lows of 317,000 (4-week MA), while nonfarm payrolls rebounded to 192,000 in March, nudging the 12-month average up to a respectable 187,000.
Exhibit 3: U.S. vehicle sales rebound in March; U.S. jobless claims decline to lowest level in years
13.013.514.014.515.015.516.016.5Feb-12 Aug-12 Feb-13 Aug-13 Feb-14
U.S. Total Light Vehicle Sales (SAAR)
(in millions)
 Other economic indicators we track are pointing to a potential improvement in economic data in the coming months. The U.S. Citigroup Surprise Index, which tracks economic releases relative to expectations, has bottomed in the spring/summer in each of the last four years (Exhibit 4). We believe this could play out again this year. Many of the major economies we track are accelerating, with Purchasing Managers Index (PMI) readings well above the 50 boom/bust level, and up from weaker readings six months ago. China is the exception, with the region clearly decelerating. From our perspective, both U.S. and global economic data are pointing to an improvement in the coming months.
Exhibit 4: U.S. economic momentum set to improve; Global PMI heat map points to economic acceleration
-150-100-50050100150Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14
Citigroup U.S. Economic Surprise Index
 
Source: Bloomberg Finance L.P. As of April 1, 2014 Source: Bloomberg Finance L.P. As of April 1, 2014 Source: Bloomberg Finance L.P. As of April 1, 2014
Global PMIs1 Month3 Months6 MonthsCurrent Ago Ago Ago
Global 53.353.053.151.6 U.S. 53.753.256.556 Canada57.256.853.751 Japan53.955.555.252.5 U.K. 55.356.256.956.4 Euro zone53.053.252.751.1 Germany 53.754.854.351.1 France52.149.747.049.8 Italy 52.452.353.350.8 China50.350.251.051.1
 
>= 5252 to 50<= 50
Source: Bloomberg Finance L.P. As of April 1, 2014
 
2003004005006007006008001,0001,2001,4001,6001,8002,000Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14
S&P 500 & U.S. Initial Jobless Claims
S&P 500 (LHS)U.S. Initial Jobless Claims 4-Week MA (RHS)(inverted)

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