After hitting all-time highs last week, the markets quickly sold off ahead of first-quarter earnings, with Alcoa kicking things off Tuesday. Both the S&P 500 (SPY) and Dow (DIA) were down a little over 1% on Monday’s close.
Earnings and company guidance will be very important this quarter as we make the much-needed transition away from Fed stimulus. Rather than relying on Fed liquidity to drive markets higher, investors will be attaching much greater weight to the direction of the economy, earnings, and what corporate executives are forecasting for the months ahead.
From our vantage point, the economy is starting to see an improvement, which is clearly reflected in the leading economic indicators (LEIs) we follow. Of the thirteen, which cover a wide range of forward-looking data related to manufacturing, housing, services, and more, ten are positive, one is neutral, and the other two are down mostly due to regional weather-related effects.
Thus, with over three-quarters of the LEIs currently in positive territory and the likelihood of data improving in the other two as record-breaking cold and snow lay behind us, things are looking fairly optimistic in the U.S.
Another major reason we think investors shouldn’t get too bearish is due to the recent acceleration of credit growth in the economy. As I explained in my recent Big Picture broadcast, “Where the Credit Runs Through It,” when credit starts to pick up that means banks are lending, consumers are taking on new loans, businesses are in expansion mode and hiring, which, overall, reflect an improving economic outlook.
That doesn’t mean we can kick our feet back and go fishing.
One of the major uncertainties, as mentioned in the beginning, is whether the market will continue to remain at all-time highs as stimulus is slowly withdrawn. Currently, it appears the economy is picking up steam, but there are more important questions outside of the U.S. still to be answered. With a significant portion of S&P 500 revenues coming from overseas, will corporate profits be able to weather weakness in other parts of the globe? Similarly, will China’s economic slowdown take place gradually and allow for a soft-landing or, more abruptly, as many analysts fear with a hard-landing?
As the world’s largest central bank withdraws liquidity from the system, major investors around the globe will be watching whether this transition from higher liquidity, lower economic growth to lower liquidity, higher economic growth (at least in the U.S.) can be pulled off successfully.
During this key transition, it is reasonable to expect greater volatility and lower returns this year than the prior two, with the market likely allocating greater weight towards undervalued dividend-paying stocks and less towards momentum plays.
Given the economic backdrop of the U.S. and the uncertainties associated with tapering, investors should keep their eye on companies with strong balance sheets, lower P/E multiples, increasing dividends, and that are also buying back their stock. In an improving economic environment, areas to consider are energy, financials, technology, and industrials.
As far as bubbles go, we don’t believe the stock market as a whole is in one, though we advise caution with many of the high-priced social media and momentum stocks that have recently gotten hit. Value and proper stock selection this year will be key as the removal of Fed liquidity places a premium on companies with good fundamentals and stable returns.
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