Stock Market Volatility Is Expected
February 4, 2014 § Leave a comment
As I write this, the S&P 500 is trading just above what we believe is the area of and for some significant support at 1750. It is likely that this support level will be tested as investor sentiment has gone from being very constructive and bullish to now negative and bearish.
Unlike the adrenalin laden “talking heads” one can watch on the television business shows this morning, or the caffeine (and other substances) jacked up hedge fund traders, we tend to take a slightly longer view than an 8 hour “clip”. You might remember the adage “trade on sentiment, invest on fundamentals”. We are investing on fundamentals and, hopefully, taking advantage of sentiment which provides opportunity for those of us who are unafraid and confident in our investing discipline.
We do view the current market volatility as “normal” and expected and believe that it presents the opportunity to put new funds to work as well as providing the opportunity to rebalance portfolios, sloughing off the “old” and “tired” stories, for newer names with more efficient upside potential.
Our view of the macro-economic world remains favorable to investment in stocks. As we know, however, equity investing requires patience and a cool, calm head, not a temperament that is rattled by some opinion on the television or by momentary movements in account values.
Why aren’t we afraid here? Simply put, corporate profits drive earnings which drive stock prices and corporate profits are increasing. According to FactSet, the blended growth rate for Q4 S&P 500 EPS currently stands at 7.9%, up from 6.4% at the end of last week. This is above the prior four quarter trailing average of 3.8%. A review of the data reveals that only financials and energy revenues are significantly lagging estimates of revenue growth. This would support our thesis that commodity prices will continue to remain soft due to a slowing China and that until interest rates move higher, traditional financials will continue to have to fight for higher earnings through share buybacks and other balance sheet strategies.
We are in the “thick” of earnings season and with just over 50% of the S&P500 companies having reported earnings, 75% of them have beaten consensus earnings estimates. So it appears to us that U.S. large cap companies are performing better in the earnings departments than expected.
The macro-economic backdrop has some weather related chatter (oh, sorry… that is a very cold pun…) (December and January economic data) associated with it at the moment which will negatively impact some of the economic data in coming weeks, but my view is that those analysts who have chosen to express a chilly view may be left out in the cold unless they warm up to the following: (again, sorry, it must be my Buffalo roots…) For example, jobs growth and housing data are likely to have slowed a bit. Increased usage in natural gas and higher heating fuel prices will take money out of the consumer’s pocket, leading to concerns of a renewed U.S. economic slowdown. Even if this develops, it is weather related and a momentary blip, in the larger scheme of things.
I believe that there are a number of U.S. based “tailwinds” that militate continued equity ownership. Declining commodity prices are at the top of my list, which lead to low/slow inflation. Higher domestic corporate profits are improving consumer confidence as well as pushing jobs growth. Banks are more willing to make loans, including mortgage loans, though U.S. mortgage rates had pushed higher but seem to be moderating in the past few days as the 10 year U.S. Treasury rate has fallen back to 2.6% from slightly above 3% just a few weeks ago. The U.S. based energy renaissance, the pickup in U.S. based manufacturing, and higher 401k balances all work in tandem to improve the U.S. based economic outlook.
Headwinds might exist, not the least of which is emerging market stagflation. It is a reason why we’ve underweighted emerging market bonds and stocks. While we believe that there are “green shoots” in Europe, that recovery is fragile and one of the European “big three, France, has some significant economic, political and social issues that could slow the Euro-recovery.
Looking forward at the economic fundamentals, we believe that while the frigid U.S. weather will negatively impact December and January data, the economic recovery and firmer stock prices remain in place. Specifically, I think that the U.S. housing recovery will continue, though at a moderate pace. Employment gains will continue to be made and are being driven by corporate profits which, according to Cornerstone Macro, have increased 114% from their recession lows. U.S. GDP growth is improving, consumer spending is rising, and capital expenditures are increasing. Inflation is low. Perhaps most important is that China continues to slow as its central government and banks try to cool off its overheated economy. As a result, the Chinese leading economic indicators are down while those in the U.S. are higher, China is tightening its monetary policy while the U.S. continues to be accommodative, all of which impact commodity prices and the U.S. consumer’s wallet.
In the shorter term, we view the technical measures for U.S. stocks as fairly positive, with the exception of sentiment. With the recent volatility, however, I think that bullish sentiment has dissipated and has been replaced by a strong negative overtone which tends to be often constructive for stocks. The trend is a bit higher by our measure, momentum at the moment is soft, breadth and leadership are both positive in the U.S. equity markets. In our view, the things making us at all cautious are seasonality and concerns over the emerging markets.
So we view the current stock market declines as expected and healthy and as setting the stage for a broader longer term advance.
Lastly, I want you to know that our position is supported by the “Super Bowl Indicator”. As you and I know, this is a wholly illogical indicator that has a surprisingly high history of being “correct” in the last 37 of 47 years according to Dow Jones. The theory is that the stock market will gain for the year if an NFC team (Seattle is an NFC team) or an AFC Team that was original NFC team wins the game. If an AFC team wins, the market will end the year lower. The indicator has been correct 78% of the time. Because Seattle is an NFC team and won the game, one might predict a higher market at the end of the year. While I am not a devotee of the Indicator and believe that it’s a case of purely random results, it might be a source of solace if you’re feeling queasy as the market acts irrationally here. Next time, we’ll talk about the “Hemline” Theory.
While we don’t like down market volatility, we don’t believe that the current stock market declines are overly worrisome at this point. Should you have any questions, or like to discuss whether we should simply run defense with the Super Bowl Theory, please feel free to give me a call or email me.
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