Friday, August 14, 2015

Mid Summer Market Musings

As of August 14, 2015 the S& 500 index closed at 2083.39 + 1.2% YTD, the DJIA at 17,408.30 -2.3% YTD. Those two trailed the NASDAQ Composite +6.3% in a bifurcated year where healthcare stocks lead the winners and energy shares the losers More than 60% of stocks are trading below their 200 day moving averages suggesting a correction has been ongoing for some time. 56% of SPX stocks are down 10% or more from recent highs.

SPX is expected to earn $118.98 in 2015. The 2015 P/E ratio is 17.5x with an Earnings/Yield (Earnings /Index Price) of 5.7%. Forward 12 month SPX earnings are projected to be $127.40 according to Factset deriving an Earnings/Yield of 6.1 % and a P/E ratio of 16x. This implies stocks are not expensive by historic comparisons and are cheap relative to bonds.

With 87% of companies reporting earnings for Q2, 73% have reported better than expected numbers, equal to the 5 year average, while only 51% reported better than expected sales, below the 5 year average. Much of the sales drag was due to a stronger U.S. dollar mostly hurting our international companies.

While earnings have grown at +5% on average during the past 3 years the S&P 500 index has appreciated about 3 times as much per year. The stock market‘s P/E ratio jumped from 13x in 2013 to 16x currently.

This increase in P/E ratio indicates rising confidence by investors that stocks are superior investments to alternatives namely, commodities, bonds, real estate, and cash.

This fact of life may seem incongruous with earnings growth at +5% and GDP growth averaging +2% this recovery the slowest in post WW II history.

Many investors have not fully participated in this recent bonanza and are understandably frustrated.

Raising from the near collapse of our financial system in 2008 this bull market has lasted longer and advanced further than the average experienced over the past 70 years.

Crude oil prices at $42.50 for West Texas Intermediate have touched 6 year lows recently due to increased North American and Saudi supply coupled with slower than anticipated demand from global economies .The recent concern over China’s stock market dive and a possible Grexit from the EU have caused stock markets to tumble and the U.S. dollar to rally.

Stocks in Australia -10%, Canada -13%, Brazil -28%, Mexico –9%, South Korea -11% & Taiwan -9.3% give the impression that ” global recovery” may be coming to an end. Big Cap China stocks are only down 3.1% YTD after all the gut wrenching headlines, but fears of a meltdown abound.

June and July saw $22 Billion in outflows from U.S. equity funds. At the same time, the Federal Reserve has indicated that it wants to move off –ZIRP - ZERO interest rate policy, which has been in place since 2008.

A move toward a” normal” rate policy will demonstrate to investors that the “financial crisis” has passed. The IMF has, however, asked our Fed to wait until 2016 before they raise rates given weakness in Emerging markets and slow recoveries in Europe and Japan.

U.S. 10 year Treasuries yield 2.20% nearly unchanged on the year. Short rates, however, have moved up in anticipation of the Fed’s next move.

Investor sentiment according to Investors Intelligence shows 42% Bulls versus 18.6% Bears. The Individual AAII Survey results are: 30.5% Bulls, 33.4% Neutral, and 36.1% Bearish. Both surveys are well off their bullish highs with complacency outweighing bearishness.

Market breath has narrowed of late which indicates fewer stocks are holding up the averages, leading us to conclude that the long overdue 10% correction in stock prices is at hand. The DJIA has gone since October 3, 2011 without such a correction which happened every 18 months on average since 1945. The longest period without a 10% pullback was 82 months during the 1990 -1997 run.

Some investors fear “impending doom” after two 50% market declines in the past 15 years. Children born before the 1930’s Depression, which was far worse than our Great Recession, never forgot those days and acted in a financially cautious manner for most of their lives.

Investors have similar bad memories and given the fact that baby boomers control most liquid assets in the U.S. we seem to have the “most hated” bull market in memory.

In sum, we have had 3 above average return years in the U.S. stock market: 2012-2014. We are overdue for a 10% market correction but it’s no sure thing. The global economy appears to be weakening judging by falling stock markets and commodity prices. U.S. interest rates are soon moving up, as the FED lifts off its 8 year ZIRP regime.

Is it time to reduce exposure to stocks for the near term? The answer might be yes as we are already in the midst of a stealth correction. Is it time to panic and head for the hills? The answer is emphatically, no!

This period of uncertainty likely ends after the Fed initially raises rates. Stocks have historically resumed their upward trends once the Fed moves. Only if we suffer an unexpected economic contraction will stocks turn tail.

We have come far in deleveraging the global financial system. Central bankers are fighting deflationary trends which have pushed up asset prices but have to ignite real world growth.

While short rates are soon going higher this signals that our economy is off the respirator not a dying patent.

Doug Coppola
John Coppola
August 14, 2015

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