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: Last week, we discussed the break down in small-cap stocks at the start of July. At the time, the S&P 500 seemed to be holding up relatively well in comparison, but has since declined noticeably over the past week. It’s off about 3.4% from its recent all-time high. Is this the beginning of the pullback, or a correction?
Stovall: I like to say that market declines of 0-5% are frequently regarded as noise, and as is usually the case, the closer you get to the 5% decline threshold, the louder the noise becomes. Whether this is the long-awaited correction is still unknown, but if we look at the small-cap stocks as a leading indicator, then the answer might be yes. If not now, then it may come pretty soon.
The S&P SmallCap 600 P/E ratio on 2014 estimates for earnings look tolerable at 20 times, but earnings per share growth needs to be more than three times of what is projected for the S&P 500. We think that’s a pretty Herculean task.
What’s more, the S&P SmallCap 600 is currently trading more than 20% above its median relative valuation as compared with the S&P 500 over the past 15 years. So using mountain climbers as an analogy, a more precipitous small cap fall from this steep valuations slope would threaten to drag its tethered large-cap brethren with it.
EQ: The recent decline has largely been attributed to the uncertainty around the Fed’s timetable for tightening rates. The Fed currently seems to be focused on trying to balance the perception of where the economy is right now. Why would the Fed want to keep rates where they are if the economy is growing, even if it’s ahead of their timetable?
Stovall: Investors don’t like surprises, and a Fed that is likely to tighten rates sooner than expected could be categorized as a surprise. Higher rates are not good for the market for a variety of reasons. First off, higher interest rates slow economic growth. Second, higher interest rates make the present value of future earnings or cash flow streams worth less. Third, higher interest rates cause an increase in interest expense for companies that issue a lot of debt, which then drags down earnings.
Also, while we don’t have the problem yet, as interest rates rise, they make bonds more attractive from a substitution standpoint. Usually, higher rates are things that investors will tolerate, but I think that they’d rather have ample warning so as not to be overly concerned.
EQ: Throughout the recovery, the Fed had been focused on a specific threshold on unemployment, while somewhat neglecting the participation rate and the U6 measurement. Could this potentially be an indicator of significance going forward when trying to gauge the Fed?
Stovall: The U6 is the broadest measure of unemployment, under-employment, and disgruntled workers. Right now, it is still above 12%, which is more than twice that of where we are now with the headline unemployment level.
I think the Fed is basically saying that it is not thrilled with the quality of new jobs that are coming out. A lot of them are in your lower-paid industries, so they would much rather see an improvement in the number of jobs as well as the quality jobs before they are willing to raise interest rates.
Also, wages represent a very large component of inflation, and based on the most recent payrolls report, the wage component rose by 2%. Yet, when looking at the Consumer Price Index (CPI), it indicates that consumers are still losing ground because inflation is up 2.1%.
Basically, consumers are not gaining in terms of purchasing power and, as a result, I think the Fed does not want to start raising rates too soon, especially not before consumers have the ability to increase their own purchasing capabilities.
EQ: When the market becomes fixated on Fed-watching mode, there tends to be more herky-jerky movements in the market. As a result, is volatility expected to pick up from here? There seems to be more and more commentators suggesting that low volatility is a new reality in the market. Do you think that’s true?
Stovall: I think certainly that volatility is exceptionally low right now. In the past 12 months, we’ve only had about 30 times in which the S&P 500 rose or fell by 1% or more in a single day. The average since 1960 has been 60 times per year, so we’re half of what we have been over the past 50 years. And the average since 2000 has been 80 times, so we are well less than 50% of that as well.
But as investors, like hyperactive first graders playing musical chairs, continue to try to out-anticipate other investors as to what the Fed is likely to do, then I think we could see a pickup in volatility.
The closer we get to the first rate increase, I think we will also start hearing the name Edson Gould, who coined the phrase “three steps and a stumble.” It implies that the market tends to decline after three rate increases. Now, however, I think it’s more like three hints of an increase in interest rates will cause stock prices to stumble.
