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We Feel a Correction Is Coming

Posted by RAA on Sep 6, 2016 1:00:00 PM


Market_Matters_Icon_medium.jpgThe post-BREXIT rebound has pushed stocks into overbought territory. U.S. equities, in particular, look increasingly priced for perfection (meaning there is no room for error); this, when the Fed is talking more hawkishly about raising the federal funds rate, maybe even at their September meeting.

Higher U.S. rate expectations will push up the dollar, further curbing S&P profit growth. Remember that a stronger dollar makes our exports more expensive, thus impacting multi-national sales abroad. Over the past several years, share buybacks and dividend growth have added to the money coming into the stock market, propelling it higher. These trends are slowing, and according to an article in the August 29th Wall Street Journal, they are slowing at a considerable rate. Furthermore, corporate earnings are slowing as well. Lastly, the election risks in early November are bound to rise and this could have either positive or negative implications for the market, depending on who wins the election.

Earnings Estimates

After a brief selloff following the BREXIT vote, global stocks have been on a tear. The MSCI All Country Index has risen by almost 11%, while the S&P 500 Index is up over 9%, reaching a new record high. U.S. stocks appear to be priced as if nothing can go wrong. The forward P/E ratio for the S&P 500 has risen to just over 18 times earnings, well above the average since 1989. And this assumes that the E (earnings) comes in as expected. The problem here is that over the last several years, the earnings estimates have come down as each year progressed. As a result, we really don’t know what 2016’s year-end earnings will be, so the 18 times multiple could be low or it could be high.

If we look at the Shiller P/E ratio (average of 10-year P/E look-back, inflation adjusted) we see that while it is not as high as it was in late 1999/early 2000, it is not that far away (around 29 vs. around 25). What this tells us is that while the S&P 500 can grind higher over the next several months, a correction is probably in the air. By this, we are not referring to a long and drawn out correction, but a correction nonetheless. A correction is defined by a market pullback of around 10%, while a bear market is defined by a pullback of 20% or more, which we are not forecasting.

What could lead to a selloff?

So, what could lead to a major selloff in risk assets or stocks?

  • The first factor would be a rebound in domestic inflation that would force the Fed to hike interest rates faster than expected to “catch up” with being too slow in the past. Even though wage inflation has turned upward and is off the bottom, there are no signs of a recovery in actual or expected consumer price inflation.
  • Second, there would have to be a retrenchment of U.S. consumer spending. After the bursting of the debt supercycle for consumers, they have continued to spend. Without U.S. consumer spending, the global economy would take a hit as U.S. consumers are the drivers of global growth over consumers anywhere else. We don’t see this happening in the near future.
  • The last major catalyst for a big selloff would be the return of financial stress in the emerging markets. This would be driven by a “hard landing” by China and/ or the renewed commodity bear market. If oil is any indicator of commodities, we think oil has probably bottomed, so the worst of the commodity bear market may be behind us. The main risk to the energy complex is that the dollar bull market resumes, as oil is traded in dollars.

 

September Outlook

You may be reading about how September is a bad month for the U.S. stock market. According to the Stock Trader’s Almanac, September, since 1950, has seen an average decline of 0.5%. Cumulatively, over those years you could have lost 31.6% of your money by investing only in September. However, staying invested all year could have netted you 551% on a price basis, which does NOT even include dividends. Wow, the power of compounding! Compounding interest should be the 8th Wonder of the World.

The point is that September could be a rocky month, especially with rich valuations, a stronger dollar, the Fed saying that they are going to raise rates, profit margins declining somewhat, corporate earnings struggling to stabilize and even grow, and GDP growth currently in a funk even though all of these highly-paid Wall Street economists are telling us that the second half will be better than the first half, which was a positive 0.96% for GDP growth. Does that mean the second half will be +1.2% to +1.5%? Hardly inspiring.

While we are expecting a correction to “squeeze” out some of the market’s excess, at this point we do not see a bear market right around the corner. Like the Fed we are data dependent, so we keep monitoring the economic data as it comes out to determine where we should be allocating assets. To summarize, our 5% equity underweight and approximately 6% cash position is a compromise. Equities could go higher, but the risk/reward tradeoff is poor, and getting worse, as valuations erode with no chance of an economic boom.

Please contact us at (972) 684-5923 if you have any questions.

 

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security. 

Topics: Investment Updates