No really. As I’m watching global stock sell off by 3% accompanied by all but bonds, gold, the US Dollar and the Yen, I’m realizing that this is exactly what we need to see as a POTENTIAL set up for all time new highs in the 3rd quarter.
Doubt – The Necessary Evil
Going into this week, I made mention of the fact that the AAII sentiment polls were still hovering at one of their lowest levels of bullishness in recent years. Meanwhile, other shorter term polls which tend to track stocks very closely were obviously more in the bullish camp as the S&P 500 threatened to make a new high for the year – yesterday. The two measures were incongruous with each other and it didn’t make sense. Now that markets around the world are panicking on the BREXIT news, we would expect all sentiment polls and surveys to swing back together toward the bear camp. What a nice set up for a strong and healthy stock rally! It will take a couple weeks and some slightly lower prices (maybe another 2% lower) to really get everyone convinced that all hope is lost.
Now hear this. Never, not ever, not once in history, has investment sentiment correctly predicted a bear market. Bear markets start with near complete euphoria with headlines like “Are You Rich Yet?” We’re closer to the other end of the spectrum in terms of headlines with plenty of doom and gloom everywhere. Remember, human nature is one of the few dependable indicators left that remains contrarian to the direction of stock prices. Why? Because we are simple creatures. We get afraid when we lose money and we get greedy and optimistic when we make money. Sentiment figures represent the combined affect of a capitalist society that lives and dies by purchasing power. If we didn’t care about the daily condition of our wealth, sentiment numbers wouldn’t be useful. But alas… we do. So now that doubt has become the dominant theme among investors in terms of psychology, we should remain open to the real possibility that the 3rd quarter could surprise many with an upside outcome.
Under the Hood of Valuation Concerns
Valuations for the market as a whole are high by historical standards. Many have argued that valuations at these levels suggest a compressed return environment until we see one of two things happen. Either earnings will need to start expanding in absolute terms on the back of improving economic conditions or we would need to see stocks fall dramatically to a level where prices are relatively cheap again. At present, there is still very little evidence that the US economy is angling toward recession. In fact, for the last two months, the net total of economic indicators across multiple sides of the economy (housing, manufacturing, consumer, inflation, employment etc) is showing a positive trend higher.
It seems that February/March may have been the low point (-14) in the current economic cycle, which obviously corresponded to the most recent low in stocks. Now the trend in both is up. Earnings and stock prices do tend to follow economic trends pretty closely.
If we dig a little deeper into valuations, we still see two interesting opportunities. The first is that 6 of the 10 major sectors of the market are showing substantially lower valuations than the S&P 500 as an aggregate. Only four sectors are showing higher than market valuations and one of them is energy, which is now in full recovery mode. Valuations for energy will not fall back until we see earnings expand, which could be very soon. That would leave only 3 of 10 sectors showing above average valuations. Strangely enough, the most overvalued three sectors are all the defensive sectors (Utilities, Consumer Staples and Healthcare). Are investors convinced that the economy is headed toward recession? Maybe but there is most likely another more compelling reason why “the three” sectors have pushed out to higher prices driving up their valuations. The reason is also the second opportunity from the fundamental camp and it has to do with relative dividend yields. Take a look at this chart, also from Bespoke.
What you might recognize is that a great many stocks now offer dividend yields that are not only greater than the S&P 500 but also greater than the best Treasury bonds. Guess which sectors offer the greatest yields? – Utilities, Staples and Healthcare!
So investors who are scared about a recession might gravitate toward these defensive groups but others are clearly chasing dividends. No surprise these three groups have the highest relative valuations.
In summary, we have to look at aggregate market valuations critically. Yes, they are high but there are still a lot of sectors that are clearly cheap, especially those that do better in an expanding economy. Furthermore, those that are relatively high are still offering investors some real value in the form of regular dividends. Honestly, I hear this high valuation argument almost daily now. But “market” valuation cannot be your only variable in your decision of whether or not to participate in stock investing. Remember, valuations were at this same level in 1996 and stocks ran much, much higher for another four years averaging over 20%/yr. (not a forecast).
Earnings in Q3 Set for favorable Year Over Year comps
Finally, investors should know that the 2nd quarter marks the end of a very tough period for year over year earnings comparisons. Looking forward it will be much easier for companies to beat their 2nd quarter, 2015, which were very soft and low by the standards of 2013 and 2014. There will be winners and losers but we should NOT be surprised to see and hear about earnings’ expansion stories on a year over year basis. Also backing earnings is the fact that one year ago, the US dollar was a lot higher than it is today and energy was in a near free fall. Now energy is stabilizing and not acting like the earnings’ anchor that has it has been.
Just thought I would offer a little optimism for everyone on an otherwise nasty day for stocks. Always the contrarian.
Have a great weekend
Sam Jones
