This week’s Chart of the Week compares consumer confidence (based on the University of Michigan Index of Consumer Sentiment) to the performance of the S&P 500 over the past five years. As the chart illustrates, there has been a very strong correlation between consumer confidence and the performance of the S&P 500 over the past five years, as evidenced by a correlation coefficient of 0.72 over that time period.

In July, the University of Michigan Index of Consumer Sentiment came in at a level of 85.1, which was the highest level of the index since July of 2007. Given the recent combination of improving labor market conditions, a rebound in housing prices, and all time highs in the U.S. equity markets, it is not surprising that consumer confidence is on the rise. This recent rise in consumer confidence has been accompanied by a simultaneous increase of money flowing into equity mutual funds, which have seen inflows of more than $92 billion year to date in 2013, following five consecutive years of out flows from equity mutual funds (from 2008-2012 when a total of $535 billion flowed out of equity mutual funds)¹. The flows into equity funds, along with relatively strong economic data as of late, have resulted in the S&P 500 reaching all time highs during the month of July.

It should be noted, though, that there are some potential risks to consumer confidence over the near term. The July consumer confidence survey indicated that a continuation of the recent rise in interest rates has the potential to be a drag on confidence. The renewed battle over the U.S. budget, which is set to expire at the end of September – including talks of a government shutdown and possible default due to a battle over lifting the debt ceiling – is eerily similar to what occurred in the summer of 2011. During the budget negotiations in summer of 2011, consumer confidence dropped from 74.3 to 55.7, and the S&P 500 from May to September dropped 17.9%. To be sure, there were factors other than the budget battle that contributed to the steep drops in consumer confidence and the equity markets (notably, the Euro crisis was in full swing during this time period).

It is important for investors to pay attention to these potential risks that are on the horizon. Considering the tight correlation between consumer confidence and equity market returns in recent years, any event that has the potential to erode consumer confidence could result in losses in the equity market as well.

¹ According to the Investment Company Institute

The chart above illustrates the year to date outperformance of small-cap stocks (Russell 2000) versus large-cap stocks (Russell 1000). Year to date, small-cap and large-cap stocks have returned 24.8% and 20.3%, respectively. While both indices have largely been positive throughout the year, small-caps have outperformed substantially since June 24th as the stock market has come to grips with a higher interest rate environment, as an increase in Treasury yields has diminished the appeal of large-cap dividend paying stocks. Investors may be willing to take on additional risk and rotate into small-caps, in search of returns via capital appreciation rather than income growth. Additionally, with the prolonged difficulties in international markets, investors may also find small-caps attractive since a smaller portion of their sales are derived from overseas. As a percentage of total revenue, the Russell 1000 derives approximately 34% of their sales overseas, while the Russell 2000 only around 18%. Finally, as corporations sit on large piles of cash, debt is relatively cheap and organic growth remains difficult, we may see continued activity in the mergers and acquisitions markets that should benefit small-cap stocks. These factors may help explain the recent outperformance.

After 7 months of consecutive gains, the S&P 500 Index (“SPX”) dropped by 1.3% in June. While a down month in the market was inevitable, one of the primary worries for investors as we enter the second half of the year is how the stock market will react to June’s losses. In an effort to answer this question, this week’s chart examines market reactions after previous “winning streaks” were broken. For purposes of the analysis, we define “winning streaks” as positive streaks of six months or more for the SPX. From 1954 to 2012 there have been 18 such winning streaks that were broken. Because we are focused on the second half of 2013, we chart the subsequent 6 month returns of the SPX.

Of the 18 data points in the analysis, there were 16 winners (89%) with a median percentage change of 8.87%. In other words, almost 9 out of 10 times, the end of a winning streak has been followed by positive returns in the U.S. stock market. Although historical data may not be indicative of future performance, investors might take comfort from the S&P 500’s past responses to snapped win streaks.

This week’s chart of the week examines the cash holdings of companies in the S&P 500 following the recession. Since 2007, the cash per share for the S&P 500 index has risen to $329.01 for a compounded annual growth rate of 11.5%. This was the result of companies protecting themselves against another economic downturn, but as the S&P 500 has hit record highs, cash and other short-term investments have continued to grow.

Investors often view high levels of cash as a sign of inefficiency. If companies have no favorable projects to invest their cash in, it should be returned to the shareholders. The most apparent instance of this was when shareholder activists began demanding Apple (AAPL) pay out some of its cash to investors. While Apple has announced it will return $100 billion to shareholders, it partially financed this buyback with debt to avoid taxes on its overseas cash. Although these high levels of cash are often viewed negatively, it could provide investors with opportunity if and when businesses decide to use these holdings. In addition to being paid out to shareholders, this cash could be reinvested in the firm or used to make new acquisitions, both theoretically leading to increased growth for the company. However, issues such as Apple’s international taxation may continue to discourage businesses from dispersing these positions. Furthermore, holding high amounts of cash may be the new norm as companies look to avoid liquidity problems during any decline the economy might face.

On April 30, 2013 the S&P 500 Index closed at a level of 1597.57, which is the all time record high for the index. The new record high in the S&P 500, coupled with the fact that the index is up more than 105% during the four year rally since the March 9, 2009 low, has caused many market observers to speculate that the market is due for a significant correction. This week’s Chart of the Week takes a look at the trailing 12 month Price to Earnings Ratio (P/E Ratio) of the S&P 500 at inflection points of the five bear market corrections (defined as a drawdown of at least 20%) since 1970.

As the chart illustrates, with the exception of the bear market correction that began in 1980, the current 15.68 P/E Ratio of the S&P 500 is significantly lower than the valuation of the index at the inflection points of the past five bear market corrections. To put the current valuation of the S&P 500 in context, the average P/E Ratio of the S&P 500 at the end of the past five bull market runs has been 19.91, and the average P/E Ratio of the index since 1970 has been 16.39.

To be sure, the current P/E Ratio of the S&P 500 by no means guarantees that the current bull market run will continue. It does however indicate that if P/E Ratios were to return to their longer term averages (not to mention the average levels at prior inflection points), there is still significant upside potential for the U.S. equity market.

This week’s chart takes a look at the S&P 500 index in direct correlation to corporate profit earnings. Thriving on corporate profits, the S&P 500 index closed at 1593.37 this past Thursday, its highest level in history. Profits by corporations, in addition to a recovering housing market have helped expand the economy for 14 consecutive quarters. Corporate profits can be attributed to the elevated growth in emerging economies in conjunction with the positive contribution of drastically lower interest rates to the bottom line.

With corporate spreads tightening and record low interest rates, investors seeking higher returns are diverting from secure investments and saving accounts to riskier investments such as stocks. The preceding 10 months have demonstrated that stocks have advanced approximately 25%, as measured by the S&P 500, with $6 trillion of wealth created for U.S. households, institutional investors, and corporations.

With corporate profits blooming, the U.S. stock market is becoming one of the strongest bull markets in 50 years. Charged by growing signs of a recuperating economy, the S&P 500 has now recouped more than all of its losses since the financial collapse and crisis of 2008.

In this week’s chart we look at the historical gap between the earnings yield of the S&P 500 and the ten year Treasury yield. The earnings yield of the S&P 500 is the inverse of the P/E ratio and shows the percentage return in earnings for each dollar invested. We can compare this to the 10 year Treasury yield as one method to measure the difference in valuations between bonds and equities. The larger the gap is between the earnings yield and 10 year Treasury rate, the more attractive equities appear relative to bonds.

As shown in the chart, the difference between earnings yield and interest rates has been hovering near 5% for the past year. The previous time this surpassed 5% was in February 2009 which was followed by the S&P 500 bottoming that March and the beginning of a bull market. Currently, the gap is again elevated as the earnings yield has remained relatively high while ten year Treasury rates are near record lows. Could this signal that the current bull market still has plenty of room to run or that Treasury yields must soon begin to rise? This is a dynamic that bears watching over the rest of 2013.

With the Dow Jones Industrial Average setting a new nominal high this week and the CBOE Volatility Index below 14, the financial news media has been beset with headlines about the recent rally in the U.S. equity markets. Analysts’ views on the sustainability of the rally are mixed, but it is not uncommon to hear market experts warn of a pullback to interrupt the recent rally. While some may be pointing to underlying fundamentals or economic data, one could simply point to history as an indicator. This week’s chart looks at the maximum intra-year drawdown for the S&P 500 Index¹  for the last 30 years.

Since 1983, the S&P 500 Index has only had five negative calendar years. Despite this fact, 25 out of the last 30 calendar years have had an intra-year drawdown of more than -7%, and the median calendar year maximum drawdown over the last 30 years was just over -10%. Year to date in 2013, the maximum drawdown is -2.8%. Therefore, based on this data, it seems reasonable that we will see a larger drawdown at some point this year. While returns may come in above 8% again for 2013, it is unlikely that the markets will rise at a steady pace each week.

¹We use the S&P 500 instead of Dow Jones Industrial Average because it is a more commonly used benchmark by institutional investors

This week’s chart is relatively straightforward but reflects some potentially powerful messages for institutional investors. As plainly seen from the chart, 2013 to date has seen a continued run-up in the equity markets (red line): as of February 7, the S&P 500 has returned 5.8% for the year. While this is good news for all investors, it is the jump in interest rates that holds more of a mixed message for investors.

Since the end of 2012, interest rates (as measured by the yield on the 10-year Treasury) have increased by about 22 basis points, a notable jump that led to losses for most core bond strategies. If the equity markets continue their upward trend, we expect further upward movements in interest rates, which will be dilutive for bond investors. Adding some exposure to floating rate bonds (such as bank loans) may help to offset these rate increases.

However, higher interest rates are not all bad news. Pension funds that report liabilities at market rates (primarily corporate plans) actually saw their funded ratios increase as a result of higher rates, given the relative mismatch between the durations of their assets and liabilities.