Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
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EQ: April marks the beginning of the second quarter, and in this week’s Sector Watch report, you discussed the significance of this particular period. What makes this Q2 different from others?
Stovall: This is the second quarter of a mid-term election year, and historically, second quarters have been the weakest for the S&P 500, on a price-change basis as well as the frequency of advances.
In fact, the second and third quarters of the mid-term election years are the two worst quarters of the 16-quarter presidential cycle. I mention this particularly to buy-and-hold investors because since we know we could be seeing some price weakness in the months ahead, they may continue to hold and not allow their emotions to force them to bail.
I also want to remind investors that another reason to not bail is that the three best quarters of the 16-quarter presidential cycle immediately follow the two worst. So you definitely don’t want to be in cash when the market begins its turnaround.
EQ: Historically, the worst two quarters have averaged a negative 2.5 percent for Q2, and 0.3 percent for Q3 of year two. But as you said, It is immediately followed by the largest gains at 7.0 percent for Q4, then 7.0 percent again in Q1 and 5.0 percent in Q2 of year three. Given that the market hasn’t really had any time to digest the major gains we’ve had over the last couple of years, could seasonal softness give the bull market some fresh legs?
Stovall: That’s a good question because right now the momentum behind the cyclical sectors—the high-beta components of the S&P 500—cause a lot of people to wonder that, if prices lead fundamentals, what on earth could derail this fast moving train and cause us to undergo this seasonal softness that you’re talking about?
Usually, it’s unanticipated events that cause markets to decline by 10 percent or more. So it’s very hard to anticipate things that are going to be taking us by surprise.
Also, we have gone 30 months without a decline of 10 percent or more, and the average is 18 months. That, by itself, does not guarantee that we have a decline in this seasonally soft period either. However, it does remind investors that while corrections may be delayed, they are never repealed. The longer we go without a decline of 10 percent or more, the greater history says that a decline will end up being a bear market rather than a 10 to 20-percent decline.
Should we get this seasonal softness that usually occurs in this mid-term election year, then I would feel better that we end up declining 10 to 20 percent, and not slip into a brand new bear market. At the same time, it would make me feel more comfortable that the valuation and the sentiment dials had been reset.
EQ: The market will most likely need some strong catalyst to spark strong moves higher. At this point, is there anything that could potentially reinvigorate bulls?
Stovall: Right now, it seems to me that cyclical sector price momentum appears to be steamrolling this seasonal softness concern like a road crew repairing potholes on the Long Island expressway. Basically, price momentum is underscoring the bullish argument, which points to an improvement in income, a pickup CAPEX spending, a loosening of credit standards, a continued recovery in housing, and a turnaround in jobs, all of which indicate that today’s economic data still leave a lot of room for improvement.
EQ: Anyway you look at the market, it’s at least fairly valued, if not overbought. Should investors be focused more on growth versus value right now when trying to identify opportunities?
Stovall: Actually, I think investors are moving away from the protection of high dividend-paying stocks and are gravitating toward those stocks that have greater growth propulsion behind it. However, the further we go in this aging bull market, I think investors will be moving away from low-quality stocks and are now going to be gravitating toward the higher-quality stocks.
During the prior recession, the low-quality stocks were those that were priced to go out of business but did not, and therefore represent the greatest price appreciation potential. Investors are now more likely to lean toward companies that have consistently raised their earnings in each of the last 10 years, which is defined by an S&P Capital IQ earnings quality ranking of A-, A, or A+.
Companies that have these rankings have above-average consistencies of raising their earnings and dividends in each of the last 10 years. So I would tend to say that investors are going to stick with stocks (rather than rotating into cash) but might end up gravitating more toward the higher-quality larger cap issues. What’s more, while small caps have outperformed large caps in 12 of the last 14 years, they would need to see a 35-percent increase in earnings just to make their 2014 P/E estimates look palatable.
So I think greater potential lies with the larger cap, higher quality stocks than what has driven this rally in the past.