As May comes to a close, Wall Street’s traffic is looking pretty confused. Economic fundamentals look like they’re moving in the right direction – US unemployment is reducing, inflation is slowly increasing, and markets are showing positive returns across key global indexes. However, the ‘Sell in May and go away’ adage remains in the news, correction calls continue to get more pronounced by the day, and the consumer-driven sectors – highly expected to lead spring and summer’s market returns due to low oil prices – haven’t delivered yet, based on recent earnings and guidance by major companies. In our opinion, Wall Street’s sideways action is impacted by two major decisions that – unlike most things – it’s unable to influence – and both have binary outcomes: Either the US raises interest rates in September, or it doesn’t. And either Greece defaults, or it doesn’t.
Let’s look into the details. If US data continues to show improvement (unemployment gets closer to the 5% mark, inflation creeps up to 2%, more people enter the labor force, consumption increases, etc.), the Fed would raise rates. According to data from S&P Capital IQ, the US has not seen a correction – meaning a downturn of 10% or more – in 44 months, compared to the historical average of 18 months. A rate hike would trigger a major market cleansing, in our opinion, hitting overinflated asset classes including risky stocks, private companies, and the bond markets – especially the high yield sector. Abroad, countries with major current account deficits, and those dependent on imports of dollar-denominated goods such as oil, would suffer significantly. The dollar would strengthen, hurting multinational US corporations, which would likely delay capital expenditures even further. So, it wouldn’t be a rosy picture for stocks.
On the other hand, if the Fed delays the rate hike (due to poorer data than what the Fed is looking for), the exact same sectors noted above would instead do extremely well. Bad news for the economy, then, becomes good news for the markets…atleast in the short term. The outcomes would be, in effect, in opposite directions – all based on the Fed’s movements.
Now, add Greece – in parallel – to the rate hike scenario. If Greece defaults, the European Union would face a possible collapse, with Spain and other nations also looking for debt relief. This would trigger a market downturn – and with investors having already flocked to Europe this year expecting growth (The Stoxx 600 is up 16.7% YTD), that’s really not something the world needs right now. As is, we’re in a slower growth environment – a ‘new normal’, as several noted names have coined it – the last thing we need is the current growth engine to stall before it gets on the highway. Again, not a good situation for stocks.
Say, on the other hand, the euro remains intact (even though Greece defaults) and the union does not break up – which is what policy makers will strive to do, in our opinion. The Euro might get stronger, hurting Germany – the powerhouse of the region – and therefore, everyone else.
If Greece doesn’t default, of course, and its debt obligations change after reform acceptances, the markets continue to move ahead, all hunky dory. So again, we see the potential of diametrically opposite stock returns based on the Greek decision.
Add a dose of activism, buybacks, and capex decisions by US corporations (all based on the interest rate hike timing), and we’re looking at an incredibly complicated summer ahead. This week, S&P Capital IQ data analysis by the WSJ showed that companies in the S&P 500 index increased their dividends and buybacks to a median 36% of operating cash flow in 2013, from 18% in 2003. Over the same decade, those companies cut spending on plants and equipment to 29% of operating cash flow, from 33% in 2003. Factor in another expert – Byron Wien, who states in Barron’s that ‘the US industrial stock is at 22 years old – an all time high’. So, even though capex seems necessary, companies aren’t going for it, and instead, seem more keen on returning cash back to shareholders. Buybacks and M&A activity have massively contributed to earnings and revenue growth this year; according to Strategas Research, the current level of the two is less than 10% off the pre-crisis high. The interest rate hike will also impact this, because once cheap financing disappears, companies will need to make far tougher decisions on pursuing organic growth and reinvestment than they’re currently used to.
What it means for you: We’re living in a pretty binary world, with two possible outcomes for each factor. The number of factors, of course, makes the situation complex. Our recommendation is to stay diversified, think long term, and don’t jump the gun by selling or buying on the news regarding Greece and the Fed – because a factor moving may change that equation completely. Stick with the theme; as we’ve recommended earlier, the financial sector, tech and biotech stocks, small caps, and growth companies are our picks for a rising interest rate environment – so invest early, and don’t bother trying to time it. One of the finest minds on Wall Street, Burton Malkiel, has provided ample data on how market timing can prove disastrous for investors – according to him, it is ‘investors’ most serious mistake’. Make your investments based on the fundamentals and themes – everything else will fall in place sooner or later. While the complexities show both directions possible in the short term, remember that Wall Street itself is a one way road – and in the long run, investing early and staying focused means you’ll get to your destination absolutely fine.
