by Jon Markman | November 4, 2013 10:56 am
There are a lot of people expecting a correction in November or December, including one of my own partners. You can hear the forecasts on CNBC, Bloomberg television, in major publications and on the street. Experts say that the market is overvalued, that sentiment is too bullish, that consumers are tapped out, that Obamacare will ruin everything, and whatever is left will be wiped out by bird flu, Congress, the White House or the Chinese.
Yet the reality is that very few of the conditions that normally precede a major correction, i.e., a 15% decline from a high, are actually in place at this time, according to a new study by analysts at the independent, highly regarded research firm Cornerstone Macro.
The analysts argue that the two factors most prevalent at the start of every 15% correction of the past 40 years — tightening monetary policy and rising oil prices — are nowhere to be seen. And they add that valuation levels have virtually no correlation to forward one-year returns. In fact, their study shows, historically there have been more, and deeper, corrections in “cheap” markets than in “expensive” ones.
Before explaining further, here are the bears’ arguments for a correction: price-to-earnings ratios (P/Es) are rising rapidly; bullish sentiment is back to multi-year highs; margin debt is at a five-year high; and the market has gone more than 16 months without a correction, so it is overdue.
Cornerstone analysts studied the past 12 major corrections of 15% or more, some of which led to full-blown bear markets, since 1973, and created a matrix that examined the weak factors seen before each. The factors were these: a sharp rise in oil; Fed interest-rate hikes; a rise in long-term yields; an economic slowdown as measured by an ISM Manufacturing decline; consumer euphoria as measured by a Michigan sentiment index reading over 90; a valuation as measured by cheap/expensive vs. 10-year average; market leadership, as measured by whether financials and consumer-discretionary stocks were lagging; global rate tightening; and the presence of an international crisis.
Every one of the 15%-plus corrections (over a six-month span) included some, or all, of these factors, but the two that were by far the most prevalent in each were a sharp rise in crude-oil prices and a Fed rate hike, followed by a rise in long-term interest rates and a significant economic slowdown.
Since the 1970s, the study found that the only major market correction that was not spurred by Fed tightening or higher energy prices was spurred by the global financial crisis of 1998. By comparison, the analysts report, today Middle East tensions are abating, gasoline futures are at the lowest price since early 2012 and Fed rates are at rock bottom with no quantitative-easing (QE) tapering on the horizon for the next few months. “Without a major catalyst, we don’t see a large correction anytime soon,” the Cornerstone analysts conclude.
The only two red flags flying at this time are the recent rise in long-term interest rates, a slightly higher-than-average valuation of the S&P 500 Index, with the average P/E higher than the 10-year average; and the fact that financial stocks are underperforming.
One key concern of the past that is not present now is a region of the world that shows sign of causing international contagion. Some countries like India and China are struggling, but they do not show signs of spiraling out of control, and there is certainly no global-tightening cycle in gear, even in Europe, where sovereign-debt fears have dramatically eased.
As for valuation, the trailing 12-month price/earnings multiple of the S&P 500 stocks is at a cycle high of 14.8, according to Cornerstone data. That’s up a whopping two points over the past year. Yet this information by itself does not make the market expensive, because as weak as economic growth is today, it is greater than inflation. And as long as growth outpaces inflation, price/earnings multiples will continue to expand. And in any case, periods when markets have been cheap have been included some of the worst corrections, as shown in the Cornerstone chart.
The bottom line is that as long as a Fed tightening is most likely not in sight until, at least the first quarter of next year, and inflation remains extremely modest in synch with lower oil and other commodity prices, equity prices are likely to keep rising. This leads Cornerstone to conclude: “Forget the Fed: Don’t fight lower inflation.”
If this is the right approach, then every dip over the next few weeks and months will likely to bring out more and more buyers. Value stocks can still be successful at times like this, but higher-beta names — including both beaten-up retailers like American Eagle (AEO) and high-flyers like Sotheby’s, should succeed, as well as financial services providers like Visa (V) and tech newcomers like Workday (WDAY), NXP Semiconductors (NXPI), Splunk (SPLK), Guidewire (GWRE) , Infoblox (BLOX), and Tableau (DATA) .
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