Market Memo: Worry can be a beautiful thing
I’ve been pretty open about my thinking on why I think this bull market has shifted from the “the world is not ending after all” phase to the “you mean we’re actually going to grow again?” phase, with GDP growth picking up in the second half and carrying over into next year, justifying a 2,000 target on the S&P 500 for 2014. But this in no way is meant to suggest it’s going to be a steady climb up. Market transitions are always sticky, which is why our equity team at Federated is holding to our longstanding year-end target of 1,660 on the S&P. I say this even as stocks have been trading above that level the past two days on a relief rally fueled by Federal Reserve Chairman Ben Bernanke’s soothing words late Wednesday, in which he suggested the central bank will be slower to move off full-throttle monetary accommodation than some had been thinking. Still, we think near-term risks could keep stocks range-bound the rest of the summer, with modest moves up followed by modest reversals. These near-term worries include:
- Fears the Fed might move too quickly We view this as very unlikely but we can’t ignore the market’s gyrations as it vacillates between worry that tightening may come too soon to relief that it won’t. Clearly Bernanke, a scholar of the Great Depression, believes the budding recovery in the mid-1930s was snuffed out by the central bank’s tightening too soon. His news conference, along with the minutes from the latest policymaker meeting that revealed a lot of debate around the timing of when to start tapering the Fed’s $85 billion in monthly government and agency securities purchases, are helping assure the market that increases in bond yields will be gradual, not sharp. This is very good news for stocks but we still expect this timing debate to continue and to brake intermittently any significant moves up.
- Concern second-quarter earnings may disappoint There’s some nervousness about this season, which is just underway. Although we are expecting a growth pick up beginning later this year, it is important to remember that growth in the first half of this year has been even slower than usual, largely due to the impacts of sequestration, the Obama tax hikes in January, the slowdown in China, and the strengthening dollar. This is not an environment likely to produce a lot of top-line surprises, so once again we will be relying on expense management and margin expansion to carry the Q2 earnings season. On the other hand, the bar for this quarter’s earnings has been set pretty low; we’ve just had one of the highest levels of negative preannouncements in history. This suggests the market may move sideways for a while as it sorts out winners and losers, making it a stock-pickers game again.
- Worries that China or Brazil might tank Growth in these two massive emerging-market countries is clearly slowing as policymakers clamp down on credit. But their central banks have lots of resources they did not have during 1990s’ crises—both countries are in good fiscal shape, for example, and have plenty of monetary reserves—and we would expect them to use their financial wherewithal to accommodate a soft landing. Equity valuations also are very low in both countries, providing potential opportunities for brave-minded longer-term investors willing to be patient. But the bigger issue is that unexpected economic weakness does not appear to be a major threat. It’s just that the markets had become comfortable with their outsized growth, and that does not appear likely for a while at least. With the eurozone still struggling to pull out of recession, and Japan’s latest push to end a two-decade stall still in the early stages, a slower China and Brazil likely will dampen any undue market enthusiasm.
Economic reacceleration coming
Against these present day worries, we see ahead a major reacceleration as outlined in our recent “Growth set to star’’ piece. To recap, the drivers for stronger second-half growth should include: less drag from government cutbacks as the fiscal situation rapidly improves; the continued rebound in housing and autos driving more blue-collar job growth, with big multiplier effects in consumer spending and confidence; the continued build-out and boom in the domestic energy area due to the development of our newly discovered shale resources; the Japanese economic growth engine restarting after a 20-year hiatus on the back of Prime Minister Shinzo Abe’s “three arrows;” and the recovery we expect later this year in some of the emerging-market economies. We think this economic reacceleration will be particularly powerful for stocks due to the high degree of operating leverage in many cyclical companies today after years of drastic cost cutting. With earnings accelerating next year, we think stocks will benefit doubly from both higher earnings and a more attractive multiple, taking the S&P to 2,000 and maybe beyond.
The question we can’t answer is when the market begins to sniff out this earnings recovery. Given what we’ve been through since 2008, we may well be in a “prove it” mode for the stock market for the next few months. But our bigger message is this: we are in a secular bull market, not a bear. This is no time to get cute, trying to sell now and exploit a brief correction if it comes; investors who do so risk being caught short if the market sees what we see and reacts sooner than expected. In bull markets, the best advice is to buy dips, not sell rallies. If a dip comes during this earnings season, we’ll be buying In the meantime, within our model stock-bond portfolios, we remain significantly overweight domestic equities, with a tilt toward sectors that benefit most from an economic reacceleration such as financials, technology, industrials, materials and consumer discretionary stocks. We are also overweight emerging markets, which we see as deeply oversold and cheap. We are underweight defensive sectors such as consumer staples, and significantly underweight bonds. Worry can be a beautiful thing.