An Imperfect Breakout
From a momentum perspective the S&P 500 and the NASDAQ Composite appeared to have broken out on Friday. As of the close, year-to-date the S&P 500 is up 2.86% to 2,117.69 and the NASDAQ Composite, a more impressive increase of 7.52% to 5,092.08, both all-time record highs. Tempering this bullish move is the fact that over the past six months when the market was on the verge of a clear breakout, it reversed lower. Although the technical indicators are bullish on-balance, the economic data remain mixed as everyone awaits a pickup in consumer spending. First Quarter 2015 earnings are beating lowered estimates, while revenues are disappointing. Oil has risen about 15% off the lows and the dollar has stabilized after sharply rising against leading foreign currencies through the First Quarter. The Fed is expected to remain “on hold” until at least the September 2015 meeting and internationally, QE of some sort has been initiated in an estimated 40 countries. Is this rise to new highs a signal that short-term problems are in current prices and the market is beginning to take a longer view of more rapid economic growth in a “normal” business cycle?
Today, the domestic economy is moving toward self-sufficiency without any signs of business cycle recession risk. Bear markets are defined as a decline of 20% or more in the broad-based averages and can occur without a recession. However, there are always bear markets during recessions. At this stage of the business cycle it would take an exogenous shock to throw the US economy into recession. The magnitude of the risk factors mentioned by those forecasting a bear market is questionable.
- Global deflation – since the implementation of QE in most of the major countries in the developed world, the threat of disinflation turning into spiraling deflation has been mitigated, and in Europe and Japan reversed. Growth, although weak, is returning. The strength of the dollar has improved the trade balance for many of these countries at the expense of financially secure US corporations.
- Greece – the problems of Greece are owned by Greece and they will pay the price. By refusing to institute aggressive reforms, the Socialist Government does not have the cash to pay creditors and will default. The market has already priced in default; 3-year Government Bond yields are 27%, listed Greek companies trade at less than 60% of book value and Greek bank stocks are 75% below year-ago levels. Even the lead bookmaker has stopped taking bets on “Grexit” because of the large imbalance in favor of default. Contagion is unlikely and in fact, default may push other marginal countries to adopt prescribed reforms and support the Eurozone. With a Greek default, a temporary selloff is possible, but it seems the only US investors at risk are the participants of a few contrarian hedge funds.
- US corporate earnings – in our March 9, 2015 Compass we discussed the possibility of an earnings recession and the fact such recessions are not statistically significant as a leading indicator of a stock market correction. In the case of 1Q2015, the stronger dollar and the halving in the price of crude oil are responsible for most of the earnings deterioration. This weakness is expected to last through the year, resulting in estimates for the forward 4Q S&P 500 earnings of +0.6% and a P/E on this forward estimate of 17x, above the long-term average of 14x. Our own propriety research for 2,000 companies shows that for the 574 reported, an average quarterly earnings gain of 10% in 1Q2015 versus a year ago. With 40% of S&P 500 earnings coming from overseas, the dollar impact is much higher for large cap companies than mid-to-small caps.
- Federal Reserve policy - the Fed is likely to leave policy unchanged at its meeting this week. An increase in rates is inevitable, but with the economy showing little sign of acceleration, unused capacity, and without wage pressure, a rate increase may be further away than generally forecast. The underpinnings that give us 2% GDP growth and 1%-2% inflation have not changed. Even with 2%+ wage growth, the Fed will have sufficient time to adjust interest rates. There is no indication that Chairman Yellen will forsake the data-dependent policy and prematurely raise rates. The key for investors is to listen to what the Fed says and not those who tell us what the Fed should say.
- Over the past few years, many Third World countries have issued US dollar dominated debt. A rising dollar puts pressure to service this debt. Also, the unwinding of the carry trade has limited liquidity, particularly in underdeveloped country securities. But in no uncertain terms can this be considered a potential shock and in fact, a reversal may result in a net inflow into US equities.
Both oil and the euro have rallied recently, but oil is still nearly 40% lower than its 2014 highs and the dollar at 1.08 euros is well-above the 1.40 euros last year. Disruptions will continue in the energy sector and overall earnings and revenues will be influenced negatively by the strong dollar. An increase in consumer spending will eventually work its way into the system and prove a positive for GDP, but perhaps not as defining as anticipated. For example, the recent disclosure of an 11% increase in medical costs may moderate any gasoline savings. Also, the savings at the pump is narrowing, just as the summer driving season begins.
In a 2% growth environment with a reluctant consumer, and relatively high stock market valuations, there exists a potential for a fundamentally-based technical correction. As we all know, technical market conditions deteriorate rapidly in a selloff. The current valuations, while not overly extended, are viewed as excessive given current economic and earnings growth. In an environment dominated by flash and algorithmic traders accounting for upwards of 80% of volume, a technical correction would most likely be short and sharp. The long-term outlook is improving and as we move through the summer the chances of a correction should be reduced.
Markets remain vulnerable as investors and traders assess the effects of declining earnings amid fluctuating oil prices, a strong dollar, and below consensus economic data. In the short-term, there is potential for a definable correction which will offer a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during a rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and limited multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective Large-Cap domestic corporate equities.