The Waiting GameApril 6, 2015 12:00 am
The S&P 500 has been stuck in a range since last November. There doesn’t appear to be a good reason to break out to the upside; or a convincing reason for a major pullback. Yet the market feels unsettled as it bounces along with daily/weekly swings recently magnified. Hesitation is in the air.
What are we waiting for? Some want to see a steadier economic recovery; others want to know what the Federal Reserve’s plans are. Many individuals don’t want to spend gas pump savings until they know that oil prices will stay low a while longer. Businesses, which have been gearing up to hire, may be having second thoughts, due to current softer data, as evidenced by Friday’s weak jobs number.
We increasingly hear sentiments similar to the following: Our comments are in italics.
1. “Equity markets are fully valued, if not overvalued.” Forward P/E at the end of the first quarter was 16.7x vs. a twenty-five year average of 15.7x. This doesn’t mean stock prices are necessarily peaking, but rather that higher prices will likely have to rely on earnings for further momentum. As for earnings….
2. “Earnings season will be upon us soon and the outlook for Q1 is pretty grim.” Due to the decline in oil prices, the rise of the dollar, a lousy winter in the Northeast and the temporary port shutdowns on the West Coast, estimated Q1 earnings growth has turned negative for the first time since 2008, according to Brian Gilmartin at Fundamentalis, who cites the latest Thomson Reuters statistics. Estimated Q1 S&P earning growth is now (-2.8%), a sharply lower revision from earlier this year. The energy sector takes the biggest blame. With expectations of a 63.6% decline in earnings for Q1, energy is subtracting approximately 6% off S&P earnings totals. That is pretty discouraging, except…
3. “Lower energy prices are supposed to be good for the overall economy. Where are the buyers?” When energy prices fall, market analysis often favors consumer driven sectors such as health care, consumer staples and consumer discretionary stocks. This is because the energy punch usually hits first, followed by a lag before consumers and businesses adjust their spending to energy savings. So, yes, we expect the economy to pick up later in the year, but we will have to wait for confirmation.
4. “The Federal Reserve should start raising interest rates soon, and that is usually bad for stocks.” This viewpoint has been popular for over a year. Rising rates (eventually) can detract from economic growth. But right now markets are more worried about whether stock prices have been inflated by low rates, a catalyst for momentum that could disappear when the Federal Reserve changes policy. In order to assuage the market fears, the Fed has telegraphed that it will only raise rates gradually and at a pace that the economy can handle. Labor market doubts and low inflation are pushing the start date out closer to the end of the year. At the same time, markets are unlikely to entirely believe the Fed until rate increases actually happen, thus creating another “wait and see” situation.
5. “A rising dollar is bad for stocks and right now the buck seems unstoppable.” Dollar strength brings with it both pros and cons. Pros: a rising dollar usually signals a strong economy. It attracts foreign investment and encourages falling oil and commodity prices. In addition, imports become cheaper. Cons: Exports decline as our goods and services are more expensive overseas leading to squeezed profit margins. A 10% increase in the dollar is associated with a 1% decline in GDP (BCA Research). The US Dollar Index (DXY) has risen 21% since last July. We believe the uptrend in the dollar will continue, but at a much slower pace and punctuated by pockets of retreat, thus making any negative impact of the dollar appreciation more muted.
6. “The rest of the world is a Black Swan waiting to happen.” There is more good news here than sentiment recognizes. Negative headlines are masking some of the progress being made in the global economy. While the emerging market outlook does appear to be worsening (with respect to the global purchasing managers index for manufacturing), developed markets, especially Europe and Japan, are showing improving signs of growth. According to Ned Davis Research, the latest global PMI reading is consistent with a 3.1% increase in industrial production, marking modest acceleration or growth in the coming months. Of course, trends only become facts in hindsight. That means, once again, we will have to wait to feel fully confident in a global recovery.
So it is a waiting game. Having reached all-time highs, the markets are seemingly stuck in a jerky limbo. The next meaningful US rally is unlikely to grab hold until investors feel better (more certain) about oil prices, the dollar, Fed policy, earnings, valuations and global growth – all factors with positive potential for an intermediate time horizon. However, the next few months could require a bit more patience and a slightly stronger stomach than investors have been used to in the recent six year bull run.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.