‘Lukewarm’ is the best way to describe the stock market’s behavior in the past few days. With a lack of conviction, neither buyers nor sellers are stepping up to the plate, and as treading water remains in fashion, the long weekend in the United States is (hopefully) providing traders a good time to think and absorb Asian and European news – all of which is likely to heavily influence US trading in the coming weeks. The Broadway-worthy Greek drama is renewing headlines this weekend, with the Interior Ministry confirming on local television that it will not be able to make June’s debt payments. With a default and potential exit from the Eurozone looking more and more likely, the situation may open the doors for other debt-laden nations to take a similar stage left. A corresponding strengthening of the Euro, or a monetary union breakup, would hurt Germany’s export-driven economy significantly – driving the regional recovery back into the dust. Given Europe and Japan’s leadership in the global markets this year, we worry that any backtracking would put a serious wrench in the world’s growth. Meanwhile, Japan slid back into trade deficit territory in April. The weak yen and exports have played massive roles in its recovery, but ‘uncertainty lies ahead over whether exports will continue to be fueled by the health of overseas economies, particularly the United States and China’, according to local economists covered by the WSJ. And while China’s red-hot stock market continues to amaze, the remarkable episode of local companies such as Hanergy losing over half of their value in a matter of minutes – only to find that the chairman was shorting his own company’s stock before that – makes us wonder how representative the stock market is of the underlying economic fundamentals. To put simply, we’re more worried about the world in the short term than we’d like to be – and therefore, decided to stay stateside this week and put our thinking caps on regarding the world’s largest, most influential economy. Here’s what we’re thinking:
The United States: Wall Street’s had a pretty amazing run, up nearly 210% from the March’09 recession depths. While the stock markets have flourished, however, growth has been tepid, the labor force has been shrinking, and near-zero interest rates have caused massive polarization among the finest minds in the game on whether the markets are reflecting economic fundamentals – or just Fed stimulus adrenaline. Corporate cash as a percentage of total assets is at its highest levels in years – but companies continue to hoard it rather than deploy it on R&D and capex. Gas prices have plummeted, but the US personal savings rate just reached 2-year highs – meaning (the much needed) consumption spending isn’t picking up. And with 9 years of near-zero interest rates having to end sometime, the bond markets, high yield markets, and private valuations are high on our radar as potentially overvalued asset classes. All in all, while the fundamentals of the US economy are pretty solid, we believe that rates will rise sooner than later, and Yellen’s speech on Friday (along with the near-daily regional Fed speeches these days) – should serve as a notice for Wall Street that it’s time to get real. The stock market’s not a game, and when uninformed people started betting on tech stocks in the dot-com bubble, the eventual bust burnt everyone who was playing, but not thinking. Goldman Sachs, in a note last week, basically said that the S&P 500’s not going anywhere this year – and highlighted that ‘dividends and buybacks will be responsible for supporting a market where the median stock in the S&P 500 index is trading at 18.2 times earnings, putting it in the 99th percentile of historical valuation’. Major indexes barely moved when Janet Yellen spoke in Rhode Island on Friday – another sign, in our opinion, that complacency is heavy in the air. Meanwhile, the Dow Theory – suggesting that the Industrials and Transport indexes should move in sync if an economy is healthy – is also showing significant divergence over the past few months. Granted that oil price rebounds and significant airline returns over the past few years have skewed this a bit, but it’s still worth noting that the Dow Jones Transportation Average is down 7% YTD, compared to a 2.3% upside for the Dow Jones Industrials Average. Consumer staples, as well as the healthcare sector – both defensive plays – have performed phenomenally well in the recent years, and are richly valued, at 19.4x and 17.2x forward P/E, with data from Yardeni Research. Takeover premiums and break-up valuations are undoubtedly impacting the staples sector, in our opinion, while the healthcare sector remains a structural growth story of investment and scientific advances in the face of an ageing population and a friendly regulatory environment. The resonating opinion from analysts is that tech, financials, and healthcare are solid sectors to be in in the coming months. We agree, and in our opinion, financials lead the way. The expected earnings growth rate of the financial sector is the 3rd highest out of the 10 S&P 500 sectors, according to S&P Capital IQ’s Erin Gibbs – highlighted by CNBC. IAT is an interesting regional financials ETF, and in a rising rate environment, this, along with XLF, would be solid plays, for reasons outlined in our February 8th column. Meanwhile, according to JP Morgan Asset Management, ‘cyclical and small cap stocks are generally favored in a rising interest rate environment’. This is another one we agree with – for reasons stated in our April 13th column. All in all, the US remains a solid place to be, but expect sectors to diverge as innovation, productivity, rate hikes, and macro events play a major role in market returns in the coming months.
What it means for you: Investing for the long term, via a diversified exposure to the broad global markets, works – and staying patient is the key. For a shorter, 1-2 year horizon, keep an eye on the factors stated above. In our opinion, riding structural or thematic waves is fair game in a market which at times is not rational – and we believe that investors at the moment are getting a bit complacent, simply doing before thinking. Take advantage of the shortened trading week in the US markets to step back, think, and prepare for what promises to be an extremely interesting drive ahead on Wall Street in the coming weeks.
