On August 16 May-Investments updated its January Economic Forecast lunch. The bottom line was that our optimistic January forecast, which called for continued slow economic growth but a much better environment for the stock market, seems to be on target as of mid-August. While the equity market remains pretty skittish, strong earnings power and reasonable market valuations combine to provide solid upside opportunity for equity market investors unless conditions in Europe and China continue their downward slides and eventually drag the U.S. market down with them.
While May-Investments leading economic indicators are getting slightly weaker, as of mid-August our January forecast for the year remains virtually unchanged.
We’ve been waiting for the “fear bubble” to pop, which would likely allow both interest rates and the stock market to rise. For the most part, we’re still waiting for that eventuality, but one important place where we did see some sense of normalcy return to the markets was in how the U.S. market reacted to the European sovereign debt crisis. While the problems in Europe continue to crescendo, the U.S. market’s response has been more muted than it was in 2008, when Lehman was at the center of the world financial crisis, or in 2010 and 2011 when the sovereign debt crisis first appeared, only to be denied by Europe’s Central Bankers and governmental leaders.
In 2012, with Greece having paid creditors less than 20 cents on the dollar and on the verge of being kicked out of the European Union, and despite the problem of high and rising interest rates in Spain and Italy and threats that the crisis would extend to now AA rated France, volatility in the U.S. market (as measured by the so-called “Vix Index”) was much lower than in previous years. True, the market did, by our measures, go into a downturn in May. Although the downturn was severe enough to get us into risk reduction mode, it was not as severe in the past and the daily volatility was much lower than in previous incarnations of the EU debt crisis. In our view, the liquidity measures put in place in December of 2011 are having a positive impact and have prevented the crisis from jumping over the pond and spreading to the U.S. financial sector.
Nonetheless, the markets (generally and) in the second quarter (particularly) are trading as if we are already in a recession. The top performing sectors in Q2 were telecommunication services, utilities, consumer staples and healthcare – precisely the sectors which typically fair best in a recession. But instead the U.S. economy continues in its slow growth mode, with consumers continuing to spend, businesses afraid to invest, governmental entities cutting spending while imports and exports having very little impact either way. In the same fashion as predicted in the January forecast, the economy keeps moving forward, albeit at a modest pace.
Of more concern, the May-Investments Leading Economic Indicators have turned down, slightly, and need to be watched closely. Whereas in January, 9 out of 10 of the index segments were indicating healthy growth, by mid-August only 4 of 10 sectors were moving up, while half were beginning to decline. If those trends continue, May-Investments would be inclined to pull its optimistic forecast. As of mid-August, however, the down trend was too new to warrant a change in the forecast.
The biggest concerns are in the areas of global economic activity, where the slowdown in Europe is impacting economies in Latin America and Asia as well. The outlook for small businesses declined as well, and the Institute for Supply Management “New Orders Index” fell precipitously, very recently.
As a result of these mixed economic signals, the U.S. stock market rallied in a very unique way. The U.S. equity markets have risen during 2012 (so investors with 20-20 hindsight should have been aggressively positioned, “all in” as it were, yet the sectors which are performing best are the “defensive” industries that typically do best when the market is weak. Leuthold Capital Management’s research folks have noted how unusual this market is from an historical perspective. The 2012 rally is unique in many ways, but we believe it all ties back to the “all in and maximum defensive” nature of this current phase of the bull market.
Updating our industry work, the sectors with the most upside potential appear to us to include technology, healthcare, basic materials, energy, industrials, and financial stocks. High dividend yield stocks, and utility stocks in particular, are among our least favorite sectors.
Overall, it felt good to optimistic again, and it feels particularly good to be optimistic while the equity market remains in a bubble of fear, generally. While there are excesses in the bond market, and in unique sectors like the social media stocks and REITs and Master Limited Partnerships, in general the level of investor interest in the market is very low, trading volumes are low, and optimism is in short supply. It is exactly the sort of market that whets the appetite of a contrarian investor.
In the short run, contrarians often have to fight the current trend, so our contrarian interest in equities is certainly no guarantee that our positive short-term forecast won’t have to be changed. In the long-run, however, the contrarian nature of our portfolio holdings really is an encouraging sign. It means that the years of swimming upstream, as investors have had to do since valuations first got stretched in 1998, are nearing an end. Good riddance!
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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