Russell Favors Dip-Buying Strategy as U.S. Stocks Retreat Anew

  • Strategists see election, sluggish economy capping equity gain
  • S&P 500 valuation near all-time highs with profits weak

Friday's Jobs Report and the Fed's Dual Mandate

The U.S. stock market’s stumble into the fourth quarter is something investors had better get used to, according to strategists at Russell Investments.

The S&P 500 Index fell 0.3 percent to 2,161.20 at 4 p.m. in New York, weighed down by technology and consumer-staples shares, while lackluster growth in manufacturing activity did little to boost optimism on the economy. The benchmark fell as much as 0.6 percent following a bank-led rally Friday -- and further declines would present an opportunity for investors, Seattle-based Russell said in a report to clients Monday. The firm manages $244 billion in assets.

While expensive valuations will keep a lid on equity gains, the slowly expanding U.S. economy should keep stocks from cratering, making any pullback a chance to add to holdings, Russell said. And those dips are likely this quarter as investors look at a calendar peppered with risk, from next month’s U.S. presidential election to tighter monetary policy from the Federal Reserve.

“We’re not overly negative because we have a view that the U.S. economy will continue to grow, and so that effectively provides a backstop toward risky assets,” Paul Eitelman, investment strategist for North America, who co-authored the report, said by phone. “If we do get a significant selloff in the United States, we would want to buy that dip because we think the economic fundamentals are OK, but the combination of lackluster earnings and expensive valuations is driving that cautious tone.”

Russell Investments joins a group of Wall Street strategists in taking a bearish stance on U.S. equities into the fourth quarter, with concerns about everything from election politics to interest rates and valuations spoiling their mood ahead of the holidays. Among 19 surveyed by Bloomberg, the average estimate calls for the S&P 500 Index to end 2016 at 2,171 -- about 0.9 percent below an all-time high on Aug. 15.

At a current price-to-earnings ratio of 20.3, the S&P 500 is at one of the highest valuations since the dot-com era, data compiled by Bloomberg show. Stocks in the benchmark for American equity currently trade at a 21 percent premium to the 10-year average. About 6 billion shares traded hands on U.S. exchanges Monday, 10 percent below the three-month average.

The return of events that bring a high degree of uncertainty -- including potential volatility around the outcome of the Nov. 8 presidential election -- may stoke turbulence that likely would be short-lived and warrant equity purchases, the Russell strategists said. In mid-September, the CBOE Volatility Index jumped 46 percent in one week, the most since early January, only to retreat 32 percent in the following two weeks.

Taking advantage of pullbacks doesn’t necessarily mean diving in with abandon. Investors should hold fewer American stocks relative to their weighting in global indexes, Eitelman said, because the potential for greater gains exist overseas. That’s because a muted outlook for earnings and the timing of the Fed’s rate increase could derail the market. 

With the central bank likely to resume tightening in December, that could “knock markets out of their summer languor,” according to the strategists. The implied probability of a December hike is now almost 61 percent, according to fed funds futures tracked by Bloomberg. New York Fed President William Dudley suggested in remarks Monday that the central bank should be cautious in raising interest rates.

A report today showed manufacturing expanded at a modest pace in September after unexpectedly shrinking a month earlier, underscoring limited progress for the battered sector. Data on factory orders and September payrolls are due later this week.

“The manufacturing ISM is back in expansionary territory -- that augurs well for the outlook,” said Brian Jacobsen, chief portfolio strategist with Wells Fargo Funds Management LLC, which oversees $242 billion. “The Fed may have hit a pause button with the weak August number, but now they can start talking up rate hikes again.”

The next earnings season unofficially kicks off in about a week, when Alcoa Inc. reports results. Analysts forecast a drop of 1.5 percent in S&P 500 company profits in the third quarter, which would mark a sixth consecutive decline. Even if earnings have bottomed after five straight quarters of contraction, “the outlook is at best tepid,” the Russell strategists said.

Stocks are coming off of their best quarterly gain of the year, notwithstanding a volatile September that ended with a monthly drop of 0.1 percent for the S&P 500. Sentiment has been fragile in the past week, whipsawed amid concerns over the size of a potential settlement between Deutsche Bank AG and the Department of Justice tied to residential mortgage-backed securities. The Dow Jones Industrial Average lost 54.30 points Monday, or 0.3 percent, to 18,253.85.

While Russell’s outlook for U.S. stocks hasn’t changed since its prior report in July, the S&P 500 has gone on to achieve 10 fresh highs. That the market has held up so well reflects the low interest-rate backdrop and if earnings and economic growth were to improve, that could further buoy already-expensive stocks, Eitelman said.

“It’s certainly possible that the U.S. equity market could continue to grind gradually higher, but part of the reason we are cautious is because when we look at the potential upside versus some of the downside scenarios, in our view the risks are asymmetrically skewed toward a more negative outcome,” he said.

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