Markets Are Never Wrong?
The S&P 500 index gained 1.8% in the first half of 2006. The advance was surprising, considering that it obscured a lot of pain: a 4.2% decline from 2006's closing high on May 5 (also the highest close since February, 2001). From May 5 through the low close for the selloff, set on June 13, the S&P 500 lost 7.7%.
"Markets are never wrong," claimed the legendary speculator Jesse Livermore. That's indisputable -- over the long term, markets have proven themselves near-perfect pricing and discounting mechanisms. But over the short term, markets -- that real-time aggregation of the opinions and emotions of millions of participants -- can be mistaken.
The selloff in the first half was driven by fears that the world's central banks -- in particular the Federal Reserve, under the untested Ben Bernanke -- were concerned by increasing cost pressures and would raise interest rates too much. This would throw the baby of economic growth out with the bathwater of inflation, as it were, curtail economic growth in the second half of 2006, and lead to a dramatic slowdown in earnings growth across the five oceans, seven continents, and 24 time zones. That seemed to be the message of the market.
And it's wrong, in our opinion. Sam Stovall, S&P's chief investment strategist, believes second-quarter earnings, and more importantly forward guidance, will offer a much-needed revision to the doomsday thinking, and could trigger a modest relief rally in July. Come the dog days of August, however, investors will probably get jittery again, Stovall says, focusing their fears on the likely action of the next Federal Open Market Committee meeting. This could cause the first-half shakeout to resume.
But in the end, Stovall says, these declines are corrections within a bull market, which will set up the S&P 500 for an end-of-year rally stemming from clarity offered by the completion of the Fed's rate-tightening program and a conclusion to mid-term elections.
As things stand, S&P sees U.S. real gross domestic product (GDP) slowing from the 5.6% rate of growth reported in the first quarter of this year to a 2.3% rate in the fourth quarter. For all of 2006, we expect GDP to advance 3.4%, and we project that it will slow to a near-trend rate of 2.4% in 2007. We think consumers will ease up on their spending, but the slack will be made up for on the capital spending side. What's more, exports should increase, in our view, as the U.S. dollar begins weakening once again after the Fed's rate-tightening program ends. In all, we don't see a recession in 2006 and think there is only a 25% chance of one occurring in 2007.
Looking at the big picture, S&P also expects the global economy to moderate in the second half of 2006 as a soft landing materializes. Although growth should still be strong enough to support low-double-digit earnings gains, we believe it will moderate enough to prevent a major acceleration of inflation. The near-term obstacle for equities, according to Alexander Young, our global equity strategist, is that evidence of a soft landing will take time to emerge, leaving stocks vulnerable to near-term fluctuations.
On the commodity front, the broad-based rally in industrial, precious metal, and energy-related materials appears to be largely self-correcting, as high prices have led to fears of slowing economic growth, which in turn has helped cool further price gains. In addition, we believe global equities are already discounting fears of a reduction in liquidity-driven global growth, resulting in an earnings slowdown later in the year, and that downside from current levels is therefore limited.
What does this mean for investors? Young thinks that the recent selloff has eliminated some of the froth in the market and that the risk-reward ratio for U.S. stocks is increasingly attractive. The S&P 500 index is trading at 14.5 times estimated 2006 earnings, despite S&P analysts' forecast of 12% per-share earnings growth for the index in 2006. By our analysis, in the wake of the decline, the U.S. market is pricing in only mid-to-high-single-digit earnings growth, implying that significant earnings deceleration is already reflected in current valuations. However, we expect volatility to continue until market participants become convinced that the economy and earnings will not succumb to higher rates later in the year.
We recommend that investors use the periods of weakness to position their portfolios for better equity market performance in the fourth quarter and early 2007.