July 6, 2010 - Time for Quiet Reflection
We can expect a quiet week this week, for a change. The shortened holiday week will yield little economic data, the calm before the start of the earnings season next week, and little on the political agenda as Congress heads out of town for the week long Fourth of July holiday recess. However, next week heats up with a spate of important economic data, the start of earnings season, and the Senate vote on financial regulatory reform. This week’s vacuum of news and events will provide investors time to reflect on the recent economic data and market decline from the perspective of the fundamentals, valuations and technicals.
Fundamentals
The fundamentals support the view that the recent spate of softer economic data is the typical soft spot that occurs one year after the start of a recovery. Last week’s economic data that drove a 5% decline in the S&P 500 is being viewed as clear evidence of a failing recovery. However, it is actually typical of an economy transitioning from the first year of recovery to a multi-year period of sustainable growth.
Looking back over the past 60 years, about one year after the start of every recovery a soft spot emerges. Around the time of these soft spots:
- Consumer confidence declined by 13 points. Last week consumer confidence was reported down 10 points from the prior month.
- Institute for Supply Management Purchasing Managers Index (ISM) consistently fell back to about the break-even level of 50. Last week, the ISM was reported at 56.4, on its way down from the recent peak of 60.4.
- The weekly number of first-time filings for unemployment benefits rose by 49,000. As of last week, jobless claims are up 33,000 from the low earlier this year.
- The S&P 500 fell about 7% below its 200-day moving average. As of the end of last week, it is now 8% below the 200-day moving average.
Despite the concerns, these soft spots were not signs that the recovery was going to fail. In fact, in every case over the last 60 years, the recovery was successful and a multi-year period of economic growth followed. Therefore, the fundamentals suggest the current decline presents a buying opportunity, rather than a sign of a return to a bear market and recession.
Valuations
Valuations support a bullish case for stocks with the S&P 500 forward price-to-earnings (PE) ratio having fallen to 11.5. While bear markets have historically bottomed at very different PE ratios, the ratio typically rises nearly 40% from the low point peaking out after one year, then give up half of those gains in the second year of recovery as the soft spot unfolds. This time around, the market has overreacted to the soft data with the PE ratio retracing nearly all of its 30% gain to now stand about where it was at the end of February of 2009 when the 2007-2009 bear market was ending.
Since the peak of the stock market on April 23, 2010, the analyst consensus earnings expectations for S&P 500 companies over the next twelve months have been rising for every sector of the stock market. A silver lining of a soft labor market is that profit margins are widening, magnifying the impact of revenue growth during the quarter. Valuations are well below average and present an attractive buying opportunity with stock prices falling as earnings estimates are rising.
Technicals
The market environment that we forecast for 2010 consisting of low returns and high volatility make watching overbought and oversold conditions the paramount technical indicators. Overbought conditions in April of this year prompted us to take a defensive posture and to recommend underweighting stocks across investment objectives. Oversold conditions are now prompting us to recommend buying stocks.
The stock market appears oversold on many technical measures:
- The S&P 500 is now 8% below the 200-day moving average. This is about the level of oversold condition that typically marks the turning point during the recovery soft spot.
- The Relative Strength Indicator (RSI) fell to an oversold level of 30 last week.
- The percent of stocks making new 65-day lows crossed above 40%, the oversold level that has historically led to rebound.
- Stocks are down 9 days out of 10, a very rare event.
- The percentage of S&P 500 stocks above their 50-day moving average is only 4%, signaling a rare and much oversold condition.
While much is made of the “death cross” of the S&P 500 50-day moving average falling below the 200-day, it has actually been a buying signal during these periods in the past. A good example of this took place in 2004 when during the soft spot in the recovery the 50-day crossed below the 200-day on August 17, 2004, just as the S&P 500 had completed the low point of its soft spot pullback and embarked upon a double-digit percent gain over the next three months.
We continue to believe a period of above-average volatility lies ahead for investors, which favors a tactical approach to investing that seeks to take advantage of buying opportunities when markets pullback while also seeking to protect profits as markets rebound to highs. We believe the technical oversold conditions point to a buying opportunity.
Time to Reflect
Back at the beginning of the second quarter, we forecast that leading indicators of economic and profit growth would be peaking during the second quarter. We believe that it is now evident that the upward momentum in these measures did peak during the second quarter and that they are now decelerating. We had forecast that with leading indicators peaking stock market performance was likely to stall and become more volatile. Now that this has unfolded, the third quarter may hold gains for the stock market as stocks rebound from oversold conditions.
If the current soft spot proves to be a reflection of uneven data points as the economy transitions from recovery to sustainable growth, rather than a double-dip recession, the markets are likely to respond as they have in the past and rebound as more data emerges. The typical bounce in the S&P 500 after reaching the soft spot low point versus the 200-day moving average was 7.9% after one month and 10.9% after three months.
IMPORTANT DISCLOSURES:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The P/E ratio (price-to-earnings ratio) of a stock (also called its “P/E”, or simply “multiple”) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.
Relative Strength Index (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.
© LPL Financial
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