Glass Half Full (or empty?)

Published at Jun 10, 2014, 12:00 AM in finance by Buğra Bakan

“It all depends on how we look at things, and not how they are in themselves.” – Carl Jung (Psychologist, 1875-1961)

When the markets don’t give us a clear direction and has mixed data flowing from many different sources, depending on our bias, one can easily call it half full or half empty. Either way, we would be right. Today, one can conclude that the stock market is due a correction or that it is building momentum for an uptrend. How so?

The glass is half empty because:

We are in a seasonally weak period for US stocks. Historically, most of the stock gains occur Nov through April and summer months are typically volatile. Like any other historical data, this doesn’t always hold true. 2008 Nov through 2009 April was one of the worst periods in the stock market, and as recently as last year, May through Oct brought decent returns. Nevertheless, the probability of summer months’ weakness carries statistical significance.

This is a midterm election year, also the second year in the presidential cycle. In all four presidential years, second year has the worst record for stock market returns. Valuations are stretched, meaning stock prices are not cheap and in relation to earnings (Price/Earnings ratio) they are close to correction territory. An uptrend in stocks without improved earnings, makes it expensive to invest and less attractive.

Falling bond yields signal weak economic activity ahead. If there is one big, in fact huge, surprise for many investors for 2014 (actually, it really started in 2011, but a more widespread consensus was for 2014) was falling bond yields and rising bond prices. By now, many analysts have been speculating a much higher Treasury bond yields. In fact, the opposite has been happening due to global easy money policies by central banks, shrinking US budget deficit and less Treasury auctions, low inflation expectations and slow economic growth.

Extreme optimism can be seen in the results of the Investor Intelligence’s bulls versus bears study and mutual funds cash holdings, both of which signal an overly optimistic investor view. Extreme optimism is one of the many conditions of the beginnings of a pull back.

Housing, a locomotive sector, has been slowing down and showing signs of topping. There have been talks of Obama administration pushing for looser lending standards through FHA loans, which could help but nevertheless, current conditions signal a market top.

European markets were expected to improve much better in 2014 and so far the results are not impressive. China is trying to clean up its property bubble and Japan is working on restructuring to fuel its economy. International markets were expected to play some catch up with the US stock market but except a few isolated incidents, results are sub-par. Then why is the title of this commentary “Glass Half Full”? Because: Even though the first quarter 2014 Gross Domestic Product, a gauge of US economic activity, has been revised down to -1%, this is hugely attributed to a harsh winter season and cold weather conditions. Bad news is behind us and pent up demand could push second quarter and second half of 2014 economic growth up to 3% – 4%. Growing economy means growing earnings and more attractive valuations.

Forward looking economic indicators such as Purchasing Managers Index, Industrial Supply Management index and employment trends have been signaling a stronger growth ahead. Lower bond yields imply a lower cost of capital which is good for stocks. Increasing mergers and acquisitions activity has been very strong and is showing signs of continuing strength.

Global markets are mostly above 200 and 50 day moving averages. So the global bull market is still intact.

Europe, China and Japan central banks are signaling more monetary easing on the way, which would weaken their currencies, lower cost of capital and stimulate their economies.

Technical readings show a bounce back from more cyclical investments such as technology stocks, small cap and energy. The pullback in biotech and pharmaceutical stocks has been contained and didn’t signal a widespread weakness.

Major indexes are still above their longer term moving averages indicating upside momentum and FED, even with tapering at hand, is still accommodating.

The executive summary of all this is that the overall trend is still up with a short term pull back a decent possibility. For longer term investors, pullbacks should be viewed as buying opportunities. One of my favorite analysts never gets tired of reminding us, that a successful investor sees opportunities in downtrends, not reasons for panic. We also know that successful investors change their minds when facts change. So stay tuned with facts, don’t fight the trend, which ever direction it is headed.

Disclosure The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.