Can the Rally Continue? – Investment Ideas

Today’s positive jobs and GDP reports have helped improve sentiment a bit, but stocks have overall been moving sideways lately after making new all-time highs some time back.

To market bulls, this behavior is nothing more than a brief consolidation phase that they view as a healthy development given the rapid gains from the summer lows.

The other side is far less sanguine about what’s happening in the market, and sees this as a sign of things to come, particularly given the sub-par corporate earnings picture and other macro challenges coming the market’s way.

These contrasting views beg the question of where we go from here. And that’s my goal in this piece – to survey the landscape of bullish and bearish arguments to help you make up your own mind.

Towards the end, I will share a robust investment framework that you can rely on irrespective of whether you lean more to the bullish side or otherwise.

Let’s talk about the Bull case first:

1) The Negatives are Already Priced in: This means that the sum total of all bad or negative news about the U.S. and global economy is already well known and reflected in current prices. It seems quite plausible since questions about the Fed, the U.S. economic outlook, China and the Euro-zone’s future have been around for a while now and are no longer ‘news’ to any market participant.

2) Healthy Economic & Earnings Pictures: The GDP growth rate in Q2 may not be that much, but the better-than-expected reading still shows the economy’s resilience. Importantly, the outlook remains constructive, with growth expected to steadily improve from the third quarter onwards. The July ADP provides further evidence that the labor market is healing, which should help offset some of the negative impact from higher interest rates on the housing recovery. The corporate sector is in excellent shape, with total earnings in Q2 on track to reach a new quarterly record and the earnings growth rate expected to ramp up materially in the second half of the year.

3) Central Bank ‘Put’: Some questions about the future of the Fed’s QE program notwithstanding, the overall monetary policy stance across all the major economies, including the U.S., remains favorable and supportive of the market. What this means is that even after the Fed starts ‘tapering’ the QE program later this year, it will continue to keep short-term interest rates at the current near-zero level for a very long time.

More . . .


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Let’s see what the Bears have to say in response:

1) Market Is Pricing a Best-Case Scenario: Market prices reflect consensus expectations, and current consensus expectations for GDP and earnings growth are clearly on the optimistic side. Europe’s situation has stabilized a bit, but the region remains in a recession and will likely be a headwind for the global economy for a long time. The situation isn’t that better in China either, where the best-case scenario is a stable economic growth at rates significantly lower than what we saw in the past decade. The rest of the so-called BRICs appear to have hit a wall as well, which is having knock-on effects all over the world. It is way too optimistic to assume that the U.S. economy and corporate sector will remain immune from the negative forces swirling all around.

2) Economic & Earnings Pictures Far from Healthy: The U.S. economy is no doubt doing better relative to the rest of the world, but that’s nothing more than what the ‘cleanest-dirty-shirt’ analogy tries to convey. Housing and the labor market are doing better, but GDP growth is unlikely to materially improve from what we have experienced lately. On the earnings front, don’t let the optimistic consensus estimates for the second half of the year and beyond distract you from the fact that the picture is hardly in good shape. Estimates have started coming down already, but have plenty more room to go. Popular stock market valuation multiples that the bulls never tire of citing as reflective of under- or fair valuation start showing otherwise when more reasonable earnings estimates are used.

3) The Fed Is in a Bind: The Fed didn’t provide a fresh guidance on the ‘Taper’ question today, but the debate itself is reflective of the realization that the program can’t continue forever. Investors have become so accustomed to the Fed pumping liquidity in the market that they see no difference between ‘tapering’ and ‘tightening’. Bernanke’s clarifications and assurances have helped stall the uptrend in long-term interest rates, but they remain elevated relative to where interest rates stood through May. The Fed’s recent inability to effectively communicate its intentions about the QE program is likely a sign of things to come as they move towards unwinding the extraordinary policy of the last few years.

Where Do I Stand?

As regular readers know, the bearish case makes more sense to me than the alternative. Simply put, I find it hard to envision stocks holding their ground in the current sub-par corporate earnings backdrop. The market hasn’t paid much attention to the persistent negative earnings estimate revisions over the past year or so, likely on the assurance of continued Fed support. But with the Fed on track to get out of the QE business in the not-too-distant future, they have to start paying attention to corporate fundamentals.

Keep in mind, however, that being bearish doesn’t mean that you have to exit the market. I remain fully invested and caution against the risks of market timing. That said, it makes perfect sense to position your portfolio for a period of above-average downside risk. I advocate greater exposure to defensive and non-cyclical industries, and look for attributes that many consider boring like dividend payers with solid earnings growth profiles.

To pick such stocks, I rely primarily on the Zacks Rank, which helps me capture the essence of earnings momentum in any industry. Whether you are bullish or bearish in your near-term outlook, you move the odds in your favor by relying on the disciplined stock selection framework of the Zacks Rank.

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Sheraz Mian

Sheraz Mian is the Director of Research for Zacks and manages our award-winning Focus List portfolio. He is among the experts whose recommendations appear in Zacks Confidential.

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