When a Normal Correction Becomes Something More

When a Normal Correction Becomes Something More

The market needs to pause/correct in the near future, but even if we get a decent correction (say > 5%), unless it invalidates one or more of the 4 core reasons stocks have rallied for 2+ years (what I call the 4 pillars of the rally), then it’s a dip we need to buy.  Given we may be ready for a short term correction, I want to provide a reference sheet for sell-offs, because unless news accompanies a sell-off that invalidates one or more of these “pillars,” then the trend remains decidedly higher.

Pillar 1:  Globally Accommodative Central Banks

For the first time in history (that I can remember), all the world’s major central banks are historically accommodative.  The Fed, ECB, BOE and BOJ all have overnight lending rates below 1%, and all of them are still actively pursuing some form of quantitative easing (the ECB is shuffling toward QE “light” but they have bought PIIGS’ bonds and are providing virtually free money via their TLTRO programs).

Additionally, while the People’s Bank of China doesn’t have rates sub-1%, Chinese officials are actively conducting “mini” stimulus measures to help prop up the economy.

I’m not telling you anything new here, just emphasizing that basically the whole world is pumping easy money, which I believe is an under-appreciated support of global equities.

Pillar 2:  A Growing Global Recovery Coupled with Macroeconomic calm

Over the past several years, markets have lurched from one global crisis to another, starting with the U.S.-based financial crisis of 2008-’09, and followed by the European sovereign-debt crisis of 2010-’12.

Along the way, the Japanese tsunami crippled one of the world’s largest economies in March 2011. Then there were the three separate U.S. government funding and shutdown dramas:  the debt ceiling scare of July 2011, the “fiscal cliff” of December 2012, and the actual government shutdown of October 2013.

Throw in the Cyprus bailout of March 2013, and fears of a “hard landing” in the Chinese economy throughout ‘12/’13, and investors have had to deal with multiple (and, in some cases, overlapping) “once in a blue moon” issues.

But, for now at least, the macroeconomic horizon is as clear as it has been in six years.  And, as a result, we are seeing the global economy finally start to recover.  The U.S. economy is seeing growth accelerate … the EU has backed off the edge of the cliff and is seeing a tepid recovery (but is recovering) … Chinese growth has stabilized and the risk of a true “hard landing” has been diminished … the Japanese economy appears to be finally turning a corner … and even emerging markets are relatively stable.

Pillar 3:  Reasonable Valuations

The U.S. stock rally of the past two years has mostly been the result of old-fashioned multiple expansion, which began in 2012 once the euro-zone crisis began to fade.

Summer is when most analysts begin to switch the basis year for the P/E calculations, so we’re going to see the S&P 500 shift from trading at a high 16.5X 2014 $120 EPS, to a more reasonable 15.2X 2015 $130 EPS.

Does that make stocks cheap?  No, it doesn’t.

But, at the same time, given the larger backdrop room remains for stocks to rally further before they get prohibitively expensive. (For example, 16X 2015 EPS is 2,080 in the S&P 500, 17X is 2,210 and 18X is 2,340.)  I’m not saying we’ll necessarily get there, but the point is the market isn’t prohibitively expensive at these levels.

Pillar 4:  Sentiment toward stocks is more skeptical than enthusiastic.

Despite the gains of the past several years and an absurdly resilient rally, investors remain very distrustful of stocks, and most view this rally as simply a Fed-induced bubble that will inevitably go “pop” at some point and result in a steep, nasty correction.  And, they will likely be right one day, but the fact remains this is the most-hated bull market I’ve ever seen. Instead of hearing a litany of reasons why stocks will make everyone rich, I continue to hear much more cautious comments about why the rally can’t last and how this will all end in tears.

There is no irrational exuberance in the market. My lawn guy isn’t giving me stock tips or saying how much he’s making in the market.

Again, I’m not saying the skeptics are wrong; rather, so far they’ve been wrong. Until we get some sort of bubbling-over enthusiasm for stocks as an investment, skepticism of this rally will continue to be a quiet tailwind on the markets.

Stocks won’t keep rallying in a straight line and there will corrections (and we are overdue for one now – yesterday’s drop notwithstanding). But, in the bigger picture, as long as these four realities remain, the trend remains higher and I’m a buyer of cyclicals on dips.