Worried About a Market Sell-Off?

May 4, 2015 12:00 am

Derek M. Amey

Partner & Co-CIO

A client recently contacted me asking for my thoughts on an article which referenced that a few money managers had been sitting on “elevated” cash positions. These managers were hopeful that a correction in stock prices would be developing soon and that a sell-off would allow them to buy stocks at a cheaper price than where markets are currently. Below is my response to this client; I thought others may enjoy reading my current outlook on stocks and the economy as a whole.

Q1 was clearly soft. Although from my view, it appears many of the reasons were transitory in nature (the west coast massive port shutdowns were a huge reason for this slowdown). This may explain why stocks continue to make new highs in the face of soft data, meaning many other investors are writing off the weakness as a combination of “one-of” events.

Interestingly enough, Q1 over the last 20 years has shown itself to be consistently weak. See here:  https://pbs.twimg.com/media/CDyfcNhVAAIHTxj.jpg

(I haven’t found any studies explaining this phenomenon, although I suspect that winter weather and post-holiday spending slowdowns play a tremendous role)

This earnings season has been mixed, bears keep pointing to subdued beats on the revenue side, bulls point to 67% of companies topping earnings expectations. We want to see a few more months of data points to see if the weakness grows, or if the snapback in economic activity everyone is calling for becomes reality. New England should snap back, following that winter we just had. That seems obvious. What we want to see after the initial pent-up demand subsides, is that the trend in activity is still higher. But we’re also seeing growth around other parts of the US.

Chicago PMI (many look at Chicago as highly correlated with rest of the US) came out last week and it came in above expectations. This was important because reports to start the year were rather weak. New orders in the report surged, as did backlog orders- both key elements we want to see. What is key is if the data continues to trend higher, and at the moment, only time will tell.

Valuations in the US are higher than average, but we’re not even one standard deviation away from the 25-year average. We would have to get to 19 times forward P/E for that to occur. High valuations are not a catalyst for a pullback; they’re merely a part of an overall environment for one to occur. If economic activity does continue to pick up and that translates into higher earnings, we should see further upside throughout the rest of 2015, especially if companies start speaking more positively about the future.

What we don’t see at this moment are conditions that typically mark the end of a bull market. Things like excessive use of leverage, the Fed raising rates numerous times (starting to raise rates has historically not been the end of bull markets), narrowing leadership in equities to a small group of stocks or specific sector, or extremely stretched valuations. None of these are present at the moment.

I think it’s fairly easy to write these articles or insinuate that a pullback is coming. Because of the broken clock theory, sooner or later one will occur, just as a broken clock is right twice a day. It has been about 3 ½ years since a 10% correction has occurred, which is what feeds into many folks prognostication.  I agree that it does feel as if we’re overdue and in many ways I would welcome this. So many market commentators have been calling for a correction for so long that I think the market would react positively. I think some folks would say:

“Phew. Now that we got that out of the way I can plow more money into equities.”

The current length of time without a correction isn’t a record (the run from 1990 to 1997 was almost 7 years to the day without a 10% correction) and the 2002 bull market lasted about 4 ½ years.

To summarize, in the short-term (this summer) I wouldn’t be surprised to see a 6-7% correction. I don’t think we will get that 10% pullback because of the fact that so many people continue to sit on cash as the article referenced. I believe that they may be eager to pull the trigger ahead of the magical “10%” correction level in stocks, and so I’m just not sure it would occur. Fear about the Fed and what raising rates will do to the economy and the markets will certainly seep into the day to day fluctuations. But my base case for equities at this point is that they will continue to grind higher along with our economic activity, even if the path to higher prices is a little more jagged than it had been in the past.

Derek Amey serves as Managing Director and Portfolio Manager at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail him at damey@strategicpoint.com.

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. Derek’s opinions and comments expressed on this site are his 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.