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: We discussed that 2013 was a pretty calm year for the S&P 500 in terms of volatility. In this week’s Sector Watch report, you included a chart displaying the Rolling Number of Days in a 12-Month Period in Which the S&P 500 Rose/Fell by 1% or More. While the average was 79, it does seem like the S&P 500 tends to be get calm or really volatile, as opposed to a steady line. Why do you think that is?
Stovall: You’re right. Since 2000, on a rolling 12-month period, we had about 80 days on average in which we saw the S&P 500 move up or down change by 1 percent or more. But we’ve had less than half of that in the past 12 months.
So even if you go back to 1969, the average is a little more than 60. So we’re still about a third below the long-term average of volatility.
I think the reason is that we go through periods of euphoria and fear. The interesting thing is that during periods of euphoria or greed, the market tends to climb a flight of stairs. So bull markets take the stairs while bear markets take the elevator. So frequently, there will be periods in which the market goes sideways and then explodes upwards. But usually in a downward market, the market just tends to tank.
You would think, however, that there would be a greater number of days on average that go down than go up, but that’s actually not true. It’s actually pretty evenly split.
EQ: How would you advise long-term investors to approach a market that will become much more volatile?
Stovall: Well, unless the investor has a time-tested rotation strategy of timing when to get in and out of the market, I think you’re best to buy, hold, and close your eyes. The reason why I talk so much about volatility is if investors are aware that there’s a likelihood of increased volatility, then they won’t be taken by surprise, and as a result, they won’t overreact and become their portfolio’s worst enemy.
I frequently like to say that there have been 60 times since World War II in which the market has fallen 5 to 10 percent. There have been about 20 times in which it has fallen 10 to 20 percent. And there have been 12 times where we’ve seen bear markets in excess of 20 percent. But more times than not, investors are better off buying than they are bailing. The reason is because pullbacks take only about two months to get back to break-even, while corrections have taken an average of about four months, and garden-variety bear markets (declines of less than 40 percent) have only taken 14 months on average to get back to break-even.
So I think investors are better served to take advantage of price weakness to add to their positions rather than to become overly scared and risk messing up their entire portfolios.
EQ: It’s still early in the Q4 earnings reporting season, but so far, the numbers have been somewhat mixed. We’ve discussed the buffer between actual numbers versus estimates in the past, but that gap seems to be narrowing in recent quarters. What are your thoughts on this trend? Do you think it will continue for Q4 numbers?
Stovall: The encouraging thing is that management has done a very good job of managing expectations. Over the past 12 quarters, what we have found is that the actual earnings within a particular quarter has exceeded the beginning-of-the-quarter estimates by more than 4 percent. In the past year, it’s been about 3.5 percent, and last quarter we beat expectations by a bit more than 2 percent.
So yes, the longer to intermediate to near-term trend has been decelerating. I would tend to think that as we approach the latter stages of this bull market maybe analysts will become a little bit better at estimating what earnings are likely to be. Still, companies do a very good job of guiding lower so that they have an ability to ensure that they beat by a penny or so.
So because this fourth quarter 2013 estimates started out at 5.8 percent, which is pretty much equal to where we ended up in the third quarter of 2013, that’s an encouraging sign. If the trend holds, and we see the actual numbers be better than the estimated numbers, then the implication is that we can exceed the estimates by 1, 2 or 3 percent or more.
EQ: You also address the spread between earnings yield of the S&P 500 and that of the 10-year Treasuries. While the spread is the tightest since 2011 before the market sold off, you think that this isn’t as bearish as most on Wall Street seem to think. Why is that?
Stovall: That’s correct. I computed the earnings yield, which is the inverse of the P/E ratio. I wanted to find out how much stocks were yielding on an earnings basis as compared with how much bonds were yielding on a percentage basis. I traced it back to 1988, which is as far back as S&P has data on operating earnings because prior to that Wall Street looked at GAAP results.
What I found was that yes, right now earnings to the 10-year note spread is a little more than 3 percent versus the long-term average of 0.5 percent, and we are below the 6.6 spread that we saw at the end of the most recent correction, which concluded at the end of the third quarter of 2011. So the current spread is about half of the peak spread about 27 months ago. However, we are still above one standard deviation from the long-term mean.
That implies that stocks still look attractive relative to bonds. So even though we are lower than where we were two years ago, we are still very attractively positioned when you realize that we are more than one standard deviation above the long-term mean.
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