Explaining The Recent Market Turmoil
According to the current issue of the Zacks Report, the market came under some pressure in May due primarily to inflation concerns. Starting May 10th, investors began selling any asset class that had been generating returns over the past year and rotated into defensive sectors and non-performing asset classes on the concern that unexpected inflation will ultimately sap gains.
The recent weakness presents an excellent buying opportunity as the selling is not being driven by deteriorating fundamentals.
The current rotation into defensive stocks is being driven by a change in investor sentiment as opposed to any fundamental change in earnings or interest rates. Despite the focus on the Fed, the Ten-year Treasury note rate remains relatively low.
Interest rates have generally eased back down over the last month and the yield curve is still basically flat, but with a bit of an upward slope. This is a clear indication that the bond market is far more concerned with an economic slowdown than with inflation. In fact, the yield curve is consistent with moderate economic growth going forward - a scenario which would be very positive for equities.
Additionally, the earnings yield on the S&P 500, based on 2006 earnings estimates, remains well above the yield on the U.S. Ten-year Treasury note. Currently the S&P 500 is yielding 6.63% while the Ten-year Treasury note is yielding 5.05%. This signals that stocks are undervalued relative to bonds.
Bond yields are not the only reason to remain bullish about equities despite the recent turbulence. Full-year earnings estimates rose last week. During the past week, earnings estimates were raised on 104 S&P 500 member companies and lowered on only 70 companies. Over the last month, a total of 600 estimates for the current fiscal year have been raised versus only 368 that have been cut (a ratio of 1.63). For 2007, 503 earnings estimates were raised while only 283 were cut (a ratio of 1.78). These are both relatively high readings, indicating little chance that earnings are about to collapse.
The median firm within the S&P 500 should achieve 11.8% earnings growth in fiscal year 2006. Although such growth would represent a decline from the first-quarter's 12.8% year-over-year pace of earnings growth, it is still very healthy.
At this point the greatest risk to the market is the ugly possibility of inflation combined with slowing economic growth. However, we do not believe that the economy will slow substantially as corporate earnings remain strong and the yield curve is clearly not reflecting inflation concerns.
The key question comes down to whether we are at a turning point in the U.S. economy. The U.S. economy grew 5.3% in the first quarter of 2006, rebounding from the fourth-quarter's sluggish hurricane-restrained pace. GDP growth is on track to slow to a below-trend pace near 3% in the second quarter. Surging energy prices and drag from decling housing starts help to account for the sharp near-term slowing.
We expect that core CPI inflation will subside to within the Federal Reserve's 1-1/2% to 2-1/2% implicit comfort zone. Importantly, moderate wage gains have been accompanied by robust increases in labor productivity, so that unit labor cost growth remains well behaved. The net result is that the market has more to fear from an economic slowdown than from inflation.
The concern is not that inflation will materialize but rather that the Fed has overshot and as a result pushed the economy into a contraction. The lag effect of rising interest rates on economic activity is about eight months, indicating that the rate hikes Chairman Bernanke is wedded to will not begin to show up in the macro-economic data until much later.
Conclusions: If the economy does not go into a recession and earnings growth is sustainable, then stocks will be moving much higher as they are fundamentally undervalued at current levels. Furthermore, whenever there is a large bearish sentiment in the marketplace, such as today, the market has a tendency to surprise the conventional wisdom and head higher.
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The recent weakness presents an excellent buying opportunity as the selling is not being driven by deteriorating fundamentals.
The current rotation into defensive stocks is being driven by a change in investor sentiment as opposed to any fundamental change in earnings or interest rates. Despite the focus on the Fed, the Ten-year Treasury note rate remains relatively low.
Interest rates have generally eased back down over the last month and the yield curve is still basically flat, but with a bit of an upward slope. This is a clear indication that the bond market is far more concerned with an economic slowdown than with inflation. In fact, the yield curve is consistent with moderate economic growth going forward - a scenario which would be very positive for equities.
Additionally, the earnings yield on the S&P 500, based on 2006 earnings estimates, remains well above the yield on the U.S. Ten-year Treasury note. Currently the S&P 500 is yielding 6.63% while the Ten-year Treasury note is yielding 5.05%. This signals that stocks are undervalued relative to bonds.
Bond yields are not the only reason to remain bullish about equities despite the recent turbulence. Full-year earnings estimates rose last week. During the past week, earnings estimates were raised on 104 S&P 500 member companies and lowered on only 70 companies. Over the last month, a total of 600 estimates for the current fiscal year have been raised versus only 368 that have been cut (a ratio of 1.63). For 2007, 503 earnings estimates were raised while only 283 were cut (a ratio of 1.78). These are both relatively high readings, indicating little chance that earnings are about to collapse.
The median firm within the S&P 500 should achieve 11.8% earnings growth in fiscal year 2006. Although such growth would represent a decline from the first-quarter's 12.8% year-over-year pace of earnings growth, it is still very healthy.
At this point the greatest risk to the market is the ugly possibility of inflation combined with slowing economic growth. However, we do not believe that the economy will slow substantially as corporate earnings remain strong and the yield curve is clearly not reflecting inflation concerns.
The key question comes down to whether we are at a turning point in the U.S. economy. The U.S. economy grew 5.3% in the first quarter of 2006, rebounding from the fourth-quarter's sluggish hurricane-restrained pace. GDP growth is on track to slow to a below-trend pace near 3% in the second quarter. Surging energy prices and drag from decling housing starts help to account for the sharp near-term slowing.
We expect that core CPI inflation will subside to within the Federal Reserve's 1-1/2% to 2-1/2% implicit comfort zone. Importantly, moderate wage gains have been accompanied by robust increases in labor productivity, so that unit labor cost growth remains well behaved. The net result is that the market has more to fear from an economic slowdown than from inflation.
The concern is not that inflation will materialize but rather that the Fed has overshot and as a result pushed the economy into a contraction. The lag effect of rising interest rates on economic activity is about eight months, indicating that the rate hikes Chairman Bernanke is wedded to will not begin to show up in the macro-economic data until much later.
Conclusions: If the economy does not go into a recession and earnings growth is sustainable, then stocks will be moving much higher as they are fundamentally undervalued at current levels. Furthermore, whenever there is a large bearish sentiment in the marketplace, such as today, the market has a tendency to surprise the conventional wisdom and head higher.
* * * * *
posted by Bob Moser at
6:01 PM
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