Well, here we are again in what is becoming a regular pattern: Stocks go on a nice run to close out the previous year and start the new year, turn volatile during the summer, then climb to higher highs through the fourth quarter and into the following year.
Wash. Rinse. Repeat.
As you can see from the chart below, it happened in 2010 and 2011, and 2012 is following the same script so far:
As we get ready to close out the first half of the year, the S&P 500 is up 5.9%, even with the annual volatility we’re in the midst of now, which has brought about a 6% pullback from its highs in early April. The question is whether the pattern will hold.
In this month’s visit, we’re going to look ahead to the second half of the year. Well talk about the factors that will influence stocks and what our profit strategy will be. I also have a new opportunity to tell you about that fits our strategy perfectly, and I’ll highlight five stocks for you that are currently on our Buy List and are in strong position to do well in the coming six months.
In a nutshell, here’s the story of the first half of the year: On balance, the positives of extremely low interest rates, reasonable valuations and modest earnings growth have offset the continuing fallout of the European debt crisis and the slowing U.S. economy.
These same issues will also be critical in the second half of the year as well. Looking ahead, we can already see what some of the biggest influences on stocks will be over the next six months: Europe’s debt crisis, the U.S. economy, the Federal Reserve and the upcoming presidential election. Let’s take a few moments to talk about each.
1. Europe: You’re probably sick of reading about Europe, and I’m sick of writing about it, but it isn’t going away. Greece’s future as part of the eurozone remains up in the air, as do the terms of its bailout and whether it could end up defaulting on some of its debt. Spain and Italy also remain trouble spots. Leaders are dealing not just with bailouts but also trying to come up with longer-term solutions around the idea of greater fiscal unity in Europe.
There will be flare-ups along the way, but I believe the market is learning to live with the chronic crisis. I thought it very noteworthy that the market rallied recently despite bond yields in Spain and Italy that had crept up near unsustainable levels again. There has also been a lot of talk about Greece leaving the European Union (EU), to the point that a new buzz word was created: “Grexit.” Volatility increased amid the chatter, but even investors pricing in a worst-case scenario hasn’t caused the kind of panic selling we saw last summer.
The path to resolution is a messy one, and we have to expect more back-and-forth action. Overall, I look for progress to be made in Greece and toward a European-wide solution, even if painfully slow at times, to keep the euro intact and avoid a widespread banking crisis.
2. The U.S. Economy: Of all the factors we’ll be watching in the second half, the U.S. economy is the most important because of its potential impact on corporate earnings. (Further weakening in European economies could also weigh on earnings of U.S. multinational corporations.)
There’s no doubt the economy has slowed, but at this point, there are still enough signs of growth that it’s premature to conclude we’re headed back into a recession. Jobs are still being created, albeit much slower than we would like. Auto sales have been good. And most intriguing of all, there are signs of life that housing could be on the verge of rising from the ashes. Last week we learned that U.S. home prices were up 1.3% in April, the first monthly increase since last fall, and today the National Association of Realtors pending-home-sales moved to its highest level in two years.
In about two weeks, we will start to hear directly from the companies about their expectations for the third and fourth quarters. We did see some important companies lower earnings guidance last week, including FedEx (NYSE:FDX), Red Hat (NYSE:RHT), Bed Bath & Beyond (NASDAQ:BBBY) and Procter & Gamble (NYSE:PG).
While disconcerting, I would not yet draw the conclusion that corporate profitability is flailing. Most of these companies continue to project growth in the next quarter, just not at the rate the market was expecting. As with the economy overall, corporate profitability may come under some pressure given the current weakness, but based on what we’ve seen so far, it is not yet enough to completely undo the market. Part of the recent volatility has been investors pricing in lower expectations.
As we get closer toward the end of the year, we’ll need to keep a close watch on the so-called “fiscal cliff” the U.S. faces. That refers to the combination of deep spending cuts that are scheduled to kick in, the expiration of tax cuts enacted when George W. Bush was president, and the federal budget potentially bumping up against the debt ceiling again next year.
As with Europe, political leaders need to put aside their differences and work together to come up with a better solution to foster growth and reduce debt. If they don’t, the prospect of higher taxes and lower spending could make consumers and businesses more cautious as we reach the end of the year. As I mentioned, it’s an issue for a little bit further down the road, but it will be part of the rhetoric leading up to November’s presidential election (which could be a strong positive for stocks, as we’ll talk about in a moment).
My view is that the economy will pick up steam as we wrap up the year, especially in the seasonally strong fourth quarter. Part of the reason I say that is the Federal Reserve.
3. The Fed: The Fed has certainly become one of the strongest influences on both the economy and the stock market through its policies on interest rates and fiscal stimulus. Following the decision last week to extend its “Operation Twist” through the second half of the year, it’s a virtually certainty that interest rates will remain extremely low. We’ve grown accustomed to these historically low rates, so it’s easy to overlook their importance, but they have been a major support factor for stocks in recent years. Investors can tolerate only for so long the practically nonexistent returns on Treasury bonds, CDs, savings accounts, etc.
When volatility is high, investors flee to the safety of those investments, but when fear eases, stocks become much more attractive by comparison. In addition to potential profits in the stock, many companies now pay dividend yields higher than bonds, adding to the appeal.
The big question surrounding the Fed in the second half of the year will be whether we see another round of quantitative easing (QE), which is a direct injection of stimulus to jumpstart the economy. At last week’s meeting, the Fed changed its language to indicate more easing could be on the way, and unless we see a quick strengthening in economic data, I do expect another round of QE. In the past, QE has been the fire that ignited rallies.
4. The Presidential Election: We’ve talked about the election before, but when looking ahead to the second half of this particular year, we have to mention it again. Presidential elections are historically very good for stocks. Going back to 1950, the S&P 500 has moved higher over the last seven months in 13 of the last 15 Presidential election years, according to the Stock Trader’s Almanac. That’s 87% of the time. Below is a chart going back even farther from Bespoke, showing the strong S&P 500 returns in elections years going back to 1928:
As you can also see, the pattern is playing out once again this year. Another consideration: Politics aside, Wall Street considers Republican candidates more business friendly, so if the race is tight or Mitt Romney moves ahead of President Obama in the polling, we could see even more enthusiasm for stocks.
Going After Growth We Can See
Next week, we’ll begin the second half of the year with what has become all-too-familiar summertime volatility. It can be unsettling, I know, but we’ve been here before, and there is a strong chance we will finish the year with equally familiar strength, especially with the additional catalyst of the election.
That’s why I’m excited about the rest of 2012. Yes, the volatility will likely be with us a little while longer, but we know from experience that volatility produces excellent buying opportunities. Our job is to go after the best of those opportunities. I think back to last summer when we were in the throes of a volatile market and we added innovative leaders like Panera (NASDAQ:PNRA) and Novo Nordisk (NYSE:NVO), which went on nice runs to finish the year 23% and 6% higher as the S&P 500 gained a little over 3%.
This year, growth may be uncertain for the economy as a whole, but there are again companies out there thriving despite and even because of the current environment. We’ll focus on those with a high degree of earnings visibility, meaning we can see pretty clearly the growth that is on the horizon over the next couple of quarters as well as longer term. In other words, companies that are in an excellent position to grow even if the economy continues to struggle.
I do want to mention that we may pay a higher valuation for some of these stocks than we would in a more “normal” environment. That’s the price for a higher degree of certainty, but it’s worth it. Many companies with very rich multiples, such as a relatively high P/E ratio, are doing very well right now. Solar Winds (NYSE:SWI) and Cerner (NASDAQ:-CERN), which both netted us solid profits in the first half of the year, are two excellent examples. That’s not to say we won’t consider valuation closely. I always do.
It’s just not the most important factor in the current environment.