The correction is over; time to add to equities The correction is over; time to add to equities

The correction is over; time to add to equities

Federated raises its equity overweight in its stock-bond model to 80% of maximum as sell-off creates more attractive valuations.
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We’ve felt since February that this market has been a “correction in search of an explanation” rather than a sell-off for legitimate fundamental reasons. So we’ve been biding our time, waiting to add to our already strong overweight position in our PRISM® stock-bond model portfolios until we felt the time is right.

We believe that time is now. Last week’s drawdown smelled of a market making a bottom, with sector leaders (Technology, Financials and Health Care) finally selling down—typically a sign of capitulation—and a successful retest of the S&P 500’s 200-day moving average. As a result, this week we increased our recommended equity overweight in our balanced portfolio from 70% to 80% of maximum.

Among other reasons for the move:

  • The trade scare is just that President Trump has no interest in tanking the market or economy, but he does intend to use the trade weapons he has to force a better, more fair and more balanced trade “deal” with China than we’ve gotten to date. All the economists in the world can talk until they are blue in the face about the importance of 19th-century economist David Ricardo’s theory of comparative advantage and free trade, but in no Ricardian textbook I've read does a free trade situation result in year after year of $300 billion surpluses for one country relative to another. It is worth noting that the present net trade imbalance is a drag on U.S. GDP, and closing it would raise U.S. GDP. This fact seems to get lost in all the hysteria. We continue to believe that Trump is negotiating for free and fair trade, and will get something closer to this than we’ve had in the last decade. The Chinese have far more to lose than we from a trade war, and hence their very restrained response so far.
  • The Fed & inflation Both in new Chair Jerome Powell’s post-meeting comments and policymakers in their dot plot forecasts, the Fed made clear last week that it remains on a gradual course. So as long as core inflation does not pick up, which we don’t expect, the Fed should not be an issue for stocks. As for inflation, February’s scare seems behind us and we expect the core PCE later this week will reflect that. Secular deflationary forces remain strong in the economy, as do the technology disruptors we’ve discussed before, i.e., the Amazons and Ubers that are applying constant pressure on prices across a broad spectrum of goods and services.
  • The risk-parity trade has calmed down while economic indicators are turning further up. The massive and rapid volatility-linked selling that erupted in late January on algorithmic-driven trades has virtually disappeared, a sign traders have gotten their books straightened out. At the same time, several forward economic indicators released in the last two weeks hit multi-year cycle highs, including the Conference Board’s consumer confidence and leading indicator indexes, NFIB small business sentiment and ISM manufacturing.

Up next: earnings

The next big catalyst for the market is earnings season, which starts early next month. We expect earnings to be very strong, both results and guidance, and this should help the market get its legs. We are still projecting $155 for this year and $170 for next year on the S&P, while the market as measured is trading at P/E multiples of 16 and 15 on 2018 and 2019 forward earnings, respectively. Assuming the market moves off these levels to a 20 P/E once it safely clears the current correction, our 3,100 S&P target for this year seems readily attainable. That represents almost 20% upside. We see little downside from here as we’ve already had a 10% pullback on largely spurious reasons.

To be sure, the Facebook dust-up probably is a harbinger of more pressure to come on the big tech monopolies. If that means this sector takes a bit of a break for a while, that’s not necessarily a bad thing. That said, we still think Tech’s near-term cash flow and earnings growth are likely to be relatively unaffected, so we still like this sector along with Financials, Energy and Industrials. More broadly, we still like this market, particularly now that the froth is off. 

Tags Equity Markets/Economy

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

The Conference Board's Composite Index of Leading Economic Indicators is used to predict the direction of the economy's movements in the months to come.

The Conference Board's Consumer Confidence Index measures how optimistic or pessimistic consumers are about the economy.

Diversification does not assure a profit nor protect against loss.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

The National Federation of Independent Business (NFIB) conducts surveys monthly to gauge how small businesses feel about the economy, their situation and their plans.

The Institute of Supply Management (ISM) manufacturing index is a composite, forward-looking derived from a monthly survey of U.S. businesses.

Price-Earnings Ratio is a valuation ratio of a company's current share price compared to its per-share earnings.

Personal Consumption Expenditure (PCE) Index: A measure of inflation at the consumer level.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Federated Global Investment Management Corp.