Beyond Market Turbulence

As a follow-up to my last comment, David Parkinson of the Globe & Mail reports, Despite the turbulence, strategists stay bullish:

The sight of slumping stock prices hasn’t shaken most market strategists’ confidence that the bull market still has further to fly. But they warn investors to buckle up – we could be in for plenty of turbulence.

In the wake of a selloff that has knocked the U.S. benchmark S&P 500 stock index into official “correction” territory (a drop of more than 10 per cent) in the space of a month while lopping 7 per cent off Canada’s S&P/TSX composite, strategists on Wall and Bay streets are reminding clients that the size of this correction is nothing out of the ordinary in a post-recession bull market. What’s more, they insist that the selling is being driven by fear rather than fundamentals – meaning that markets with solid growth prospects are merely getting cheaper and creating buying opportunities.

“It is difficult to be very bearish of corporate assets when growth is reasonably strong, inflation is low, margins are expanding, monetary policies are easy, and valuations are undemanding,” said economist Larry Hatheway of UBS Ltd. in London.

“In the first four months of this year, investors had become increasingly complacent to risk,” he said. “This was a market vulnerable to correction – all that was missing was a catalyst.”

However, that catalyst – a major sovereign-debt scare out of Europe – has re-awakened investors’ hyper-sensitivity to risk, a lingering effect of the credit crisis of 2008-09. The depth and speed of this risk adjustment does suggest that even if stocks can track generally higher in the coming months, they may do so in a very moody, volatile way.

“People are now a lot faster on the trigger in reducing risk. This increased volatility could be a byproduct of a new way of managing portfolios,” said Stéfane Marion, chief strategist at National Bank Financial in Montreal.

“But we have to keep things in perspective. We haven’t yet seen the collateral damage [from the European debt woes] that would upset global growth.

“In a world where credit markets remain functional, I don’t think the amount of selling we’ve seen can be justified,” he said. “The valuations we have right now are very reasonable.”

George Vasic, chief strategist for UBS Securities Canada Inc., noted in a research report that over the past 50 years, post-bear-market rallies on the Toronto Stock Exchange have all been met with corrections on the scale of what we’ve seen recently; the average pullback has been 13 per cent. Similarly, Pierre Lapointe, global macro strategist at Brockhouse & Cooper Inc. in Montreal, said the S&P 500 has routinely rallied in the year after the end of a recession, yet those rallies have all included a considerable correction within them, averaging 17 per cent.

“The next few months will remain volatile, but history tells us that the year that follows a recession is usually very profitable for equities,” said Mr. Lapointe, who reiterated his overweight recommendation on global equities.

David Bianco, chief U.S. equity strategist at Bank of America-Merrill Lynch in New York, is among several strategists who issued research notes in the past few days reiterating their earnings and stock-index targets over the next 12 to 18 months. His 12-month target for the S&P 500 remains at 1,350, a whopping 25 per cent above Tuesday’s closing levels.

He said the current S&P 500 levels imply a price-to-earnings multiple of about 12 times, far below the historical norm of 15 times. At normal P/Es, current levels are pricing in S&P 500 earnings of just $72 (U.S.) a share for 2011 – almost 20 per cent below Mr. Bianco’s “base-case” forecast, and toward the low end of his worst-case projections in the case of another global recession.

“Times like this make it clear that the risk equity premium is no free lunch, and volatility is gut-wrenching, even for the most long-term investors,” he said. “[But] we believe the best way to feel better during a correction is to buy some shares.”

I think volatility is here to stay. Itchy traders selling at the first sign of weakness, memories of 2008, and way too much risk management stifling the large portfolios, forcing managers to cut positions when the VIX rises, are all wreaking havoc on markets. Add to this market disinformation usually spread by large investment houses or their large hedge fund clients looking to capitalize on volatility, and you come away thinking that maybe the month of May is a harbinger of things to come.

But the reality is that US fundamentals have turned the corner. Allan Robinson of the Globe & Mail reports, U.S. consumers could give global stocks a lift:

The bull market needs some fuel and that will come once the U.S. jobs picture improves, incomes start to rise and consumer spending revives, strategists say.

“History tells us that a peak in the U.S. unemployment rate has the potential to sustain the equity rally – globally,” said Pierre Lapointe, a global macro strategist with Brockhouse Cooper. “We have calculated that every time the unemployment rate peaks after a business cycle, the post-recession global rally gets a second wind.”

Basically, investors bet on a recovery. “Investors realize if the jobs market gets better that means consumers will start spending again and that means profits down the road,” Mr. Lapointe said.

What is the market looking for now?

After three solid months of increased spending, economists are looking for consumers to take a breather and investors may need to be patient. Personal spending data scheduled for release Friday is forecast to have increased 0.3 per cent during April, compared with a lofty 0.6 per cent rise in March, according to a survey of economists by Bloomberg.

On the plus side, personal income is expected to have crept higher rising 0.4 per cent in April, compared with 0.3 per cent in March.

Another positive for U.S. consumers is that they have had no reason to be worried about rising prices. The personal consumption expenditures inflation data, known as the PCE deflator, measure price changes for a broad range of goods and services, excluding food and energy. The deflator also due out Friday is forecast to have declined to a 47-year low of 1.1 per cent in April, well below the U.S. Federal Reserve Board’s long-run forecast of 1.7 per cent to 2 per cent, according to BMO Nesbitt Burns Inc.

“The sharp turnaround in the labour market in recent months suggests that incomes will soon start to rise more significantly,” said Paul Dales, the U.S. economist for Capital Economics Ltd. “This will allow households to raise their savings rate without too much of a slowdown in consumption growth,” he said.

How will the market react?

So far stock markets have not reflected that bullish scenario. Investors have been preoccupied with sovereign risks concerns, which has driven stock markets lower. Last week the VIX, a measure of equity volatility, soared to 45.79 but this week it plunged to about 30.

“Only on five occasions in the past 25 years has the VIX reached such heights,” said Carmine Grigoli, chief investment strategist with Mizuho Securities USA Inc. Such elevated readings suggest emotional selling and on average the stock market has jumped 26 per cent in the following year.

And Brockhouse Cooper’s Mr. Lapointe said that on average six months after U.S. unemployment levels peak (in October, 2009) global markets increased 9.4 per cent, compared with the recent 1.1-per-cent decline. “One year after the unemployment rate peak, global equities were up 17 per cent on average,” he said.

It's easy to get all flustered in these markets. With volatility on the rise, more uncertainty over Europe's future, stocks coming off one of the worst months, it's no wonder everyone is pessimistic and bearish.

But if you look beyond the turbulence, and focus on the improving fundamentals, then a different picture emerges. To be sure, the big beta moves of 2009 are over, but going forward, there will be money to be made if you pick your stocks and sectors right. That much I'm sure of.

Below, William Greiner, chief investment officer at Scout Investment Advisors, talks with Bloomberg's Matt Miller and Carol Massar about the outlook for U.S. inflation. Greiner also discusses the outlook for U.S. stocks, corporate earnings and Europe's financial crisis.