Secular Bull Update: Time to buy the dips again
We were cautious three weeks ago on concerns early January’s decline could extend into February. It has, but the worst of the short-term pullback in equities appears to be behind us. While the market may retest the lows hit early this week, we think investors should be using this weakness to add to equity positions. Our equity team remains bullish on the full-year outlook and has not changed our 2,100 year-end forecast on the S&P 500. We especially like cyclical sectors in housing, industrials and banks. While the turmoil isn't likely over in emerging markets (EM), investors are beginning to understand the picture there is not a monolith and are distinguishing winners from losers. Federated's model portfolio allocations remain underweight EM, and we would currently only invest in select countries that appear capable of weathering the storm, such as Poland and Korea.
Despite the recent weather-related murkiness, U.S. fundamentals on balance have remained strong, with reacceleration likely in the spring and summer. Indeed, one reason for the market’s early year sell-off has been the perceived domestic economic softness, coming through in weak holiday sales reports from brick-and-mortar retailers, Monday’s disappointing ISM Manufacturing read, the poor December employment report and this morning’s soft nonfarm jobs number. This weakness most likely is more weather-related than people realize, given the horrific winter storms and brutally low temperatures in the East and Midwest in both December and January—it was the second-coldest winter in 30 years in the eastern third of the country. We were impressed by construction’s surprising strength in today’s report—it added 48,000 jobs, more than doubling December’s clearly weather-related drop of 22,000. Construction, housing and energy are three of the critical sectors behind our above-consensus 3.5% 2014 GDP forecast, so the strength here is important. The past month’s rally in U.S. Treasuries and concurrent plunge in yields also should provide some punch to housing as mortgage rates have fallen a quarter point so far this year.
Volatility need not be feared
Emerging markets remain a mixed bag, but market commentary is increasingly focused on this. Although year-to-date performance is ugly almost everywhere in the EM, we think investors are beginning to sort out winners from losers. If this indeed is happening, it would be a very good thing and reflective of a different and beneficial mindset about the EM than has been the case in past (for a good explanation of this paradigm shift, see this week’s piece by my fixed-income colleague Ihab Salib). Over the next few weeks, Federated will be watching for better relative performance out of the stronger emerging countries such as Poland, Mexico and Korea even as weak links such as Argentina and Turkey may struggle and maybe make new lows. This would be healthy and strengthen the case for “de-linking” U.S. market performance from the deteriorating fundamentals in some of the weaker EM markets. This being said, the dynamic within the weak links remains a self-reinforcing negative in our view, with valuations still not low enough to merit even nibbling.
Getting back to the domestic markets, this week’s trading suggests the lows for this mini-correction may be in. Although we thought it may lean towards the deeper end of our 5% to 10% forecast, Monday’s pullback to 6% year-to-date increasingly is looking like a capitulation low. The VIX spiked that day to nearly 22, similar to levels in last year's June and early October pullbacks. As the finishing touches are being put on what has been another solid earnings season, the economy is likely to play catch-up when the weather starts to clear, maybe in March. If the economy bounces strongly as we expect, that should drive top-line revenue growth in U.S. companies and, given their lean cost structures, this revenue growth should beget better-than-expected earnings growth. For the year, we’re sticking with $120 on full-year S&P earnings, which at a 17.5 P/E multiple, would get us to 2,100. Don’t lose sight of this longer-term view as the market goes through periods of normal—indeed, welcome—volatility. It’s time to think “buy on the dips’’ again.