Mitch Zacks
29/09/2014
Second quarter GDP was revised higher on Friday from an annualized rate of 4.2% to 4.6%. If this level of GDP growth can continue, the recent weakness in the equity markets presents a buying opportunity.
Here are a few reasons why it makes sense to continue buying the U.S. equity market:
· Higher valuations. Right now, U.S. equities are valued at a level that is slightly higher than historical levels. However, bull markets rarely end at valuation multiples that are just slightly higher than historical levels. They end when valuation multiples are substantially higher and investors are swinging from the chandeliers. While the market remains somewhat expensive, it is by no means at the level we would expect at the tail end of a bull market.
· Growing corporate earnings. If the economy continues to expand at a reasonable rate, corporate earnings growth should push the market higher. While the gains for the stock market will not be anywhere near what they have been over the past few years, most likely the stock market should appreciate around 6-9% over the next twelve months. Earnings growth is expected to be rather robust over the next few quarters.
· We're not heading in the wrong direction. The majority of the market's losses occur in periods when we have both rising interest rates and a contraction in the economy. This combination historically hits stocks with a contracting P/E multiple at the same time corporate earnings are pulling back due to an economic slowdown. It looks increasingly unlikely, however, that we will be entering such an economic environment.
· Economic expansion is still on track. The most recent GDP data suggests that we are going to see rising interest rates accompanied by economic expansion. If interest rates indeed rise but remain under historical levels, I expect the inverse to happen with P/E multiples. They should fall but remain above historical levels. If this occurs along with growth in corporate earnings, the current bull-market likely has some room to run.
Continued below . . .
· Wage inflation remains incredibly low. This results from ( 1 ) an increase in the global supply of labor due to outsourcing and ( 2 ) technological changes that are causing capital to serve more as a replacement than complement for labor. Downward pressure on wages was not caused by the last recession. Instead, it was caused by a fundamental change in the economy. Therefore, it is not likely to reverse itself any time soon. The lack of wage inflation is keeping corporate profit margins at all-time highs which is a benefit for the stock market.
· Without wage inflation, we will not see price inflation. This should enable the Federal Reserve to put off raising rates until mid 2015. Additionally, the strong U.S. dollar is putting pressure on the Federal Reserve to keep rates low in order to boost exports.
· GDP growth in the remainder of 2014 will likely average 3% or better. Supporting this sustained above-trend growth are several broad trends: receding uncertainty; improving financial conditions, including gains in household balance sheets; absence of fiscal drag; and solid employment gains. Although housing remains a concern with household formation and residential investment struggling to regain momentum, there are some positives in recent data. As GDP growth strengthens corporate earnings, the stock market should push higher. Likely, small-cap stocks will come back stronger in the remainder of 2014 as they are less exposed to the weakness in Europe.
· Forecasts are upward despite the expected end of QE3 in October. But it is important to remember that interest rates are going up because the economy is expanding. An expanding economy is a positive for the stock market even if the expansion is accompanied by rising rates. As a result, reasonably strong expected growth of corporate earnings and dividends combined with gradual interest rate increases supports my forecast for roughly a 4% gain in the S&P 500 over the remainder of 2014 and mid to high single-digit gains for the index in 2015.
Of course, there are also substantial risks to the equity market.
· Intensifying concern about a potential deflationary dynamic in the Eurozone. This is prompting easy money policies, and if true deflation does materialize it would slow economic growth in the U.S. That in turn would put substantial downward pressure on corporate earnings. Nevertheless, the natural state of economies is not deflationary. A much more likely outcome is that the Eurozone over-reacts to the deflationary pressure and, as a result, interest rates stay lower for longer than investors are anticipating. The U.S. equity markets would then be pushed higher.
· Substantial risk of a sharp slowing in China. This could have financial spillovers globally. Although a real concern, China's economy is so centrally controlled that the day of reckoning is likely farther off than most people are anticipating. One only has to look to the recent action of the Chinese government in propping up its banking system to understand why I estimate that the Chinese Government will continue to prop up the economy for several years after a recession would have naturally taken place.
· Fears of intensifying conflicts. Look to the civil war in Syria and the turmoil in Ukraine. These events could lead to additional, more serious sanctions with material consequences for European growth and adverse spillovers in financial markets. Generally, I think it is a reasonable bet that the situation in the Middle East will get worse before it gets better. As a result, we should see higher energy prices. This is a negative for consumer discretionary spending although we have yet to see energy prices spike. However, the growing global turmoil is unlikely to derail U.S. GDP growth. If anything, it will make the Federal Reserve a little more cautious about raising interest rates.
Most concerning to me is that while downside economic risks are receding, the market is too complacent. The readings on the VIX are way too low and I would not be surprised to see some near-term volatility increasing. Basically, it feels like we are overdue for a pullback.
However, while we are likely going to see some selling in the near term, the bullish thesis remains in place due to the economic expansion. As a result, any sell-off presents a good buying opportunity. At this point in time, the positives outweigh the negatives.
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-Mitch
About Mitch Zacks
Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A. in Analytic Finance from the University of Chicago.
Mitch also is a Portfolio Manager for the Zacks Small Cap Core Fund ( ZSCCX ).
by Mitch Zacks, Senior Portfolio Manager
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