Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: Global tensions are on the rise, namely with the US taking tougher stances against Syria and North Korea over the past week. Perhaps as a result, implied volatility as measured by the VIX, soared in recent days. Yet, the market has for the most part remained somewhat flat. What does this tell us, if anything, about the market right now?
Stovall: I think it’s telling us that the market is nervous. The fundamental forecasts have not changed: earnings are still expected to be up 10% for the next year, economic growth is expected to climb to the upper-2% by the end of this year, and the Fed is still likely to be raising interest rates two more times this year. But what’s causing investors to sort of freeze in their tracks is that their confidence is being held hostage by geopolitical uncertainty, and they don’t really know how to model that. Nobody really does.
What kind of reactions could we see from Russia, which is protecting its ally Syria? What kind of response might we get from China, or even North Korea, given that we are sending military ships into that area? I think investors are just getting worried right now that some geopolitical events could get out of control.
EQ: In this week’s Sector Watch report, you looked at the market’s initial reaction to the strike against Syria, as well as some historical cases for similar market shocks. For the most part, the market seems to shrug these events off. Why is that?
Stovall: We usually end up seeing a decline because investors tend to sell first and ask questions later. But the questions they tend to ask themselves are, will this event escalate? And could it then lead to either a domestic or global recession? I think, basically, they have found that the answer is no. Whether its Brexit or other shocks that have occurred within bull markets, it ends up just being something they panicked about, got out of, only to get back into. But it usually ends up being a non-event.
EQ: So, should investors use these occurrences as buying opportunities? If so, what are some good practices to implement?
Stovall: Yes, history says but does not guarantee that these do end up being good buying opportunities. What has traditionally happened is that on the very first day of the surprise, the market has declined about 2.5% on average, and it ends up bottoming about nine days later, falling a total of about 4.6%. But then you get back to break-even in an average of 18 days. That’s 18 calendar days, not trading days.
So, essentially, what you find is that the market gets close to a pullback, but once its bottomed out, it starts to take advantage of the lower prices. I would tend to say to just watch the markets and the moving averages. We’re currently flirting with the 50-day moving average on the S&P 500, so should we end up declining a total of 4.5% from that April 7 level, then history would say that it’s probably a good time to start thinking about buying back in.
EQ: You also noted four specific economic indicators that you’re watching that suggests the economy is not at risk of recession. With that said, it does feel that the wall of worry is beginning to creep up again, and the market seems a bit more susceptible to exogenous shocks now than it was a few months ago. In this market environment, what would you suggest investors focus on, and what noise to filter out?
Stovall: First off, I think investors have to acknowledge that there is a very big difference between noise, pullbacks, corrections and bear markets. Essentially, we need to see recession, or at least the fear of recession, in order for us to move into a bear market mindset. There are four indicators that I look at: Housing Starts, Consumer Confidence, the LEI Leading Economic Indicators, and the Yield Curve. They have all traditionally been in negative territory leading up to recessions, but right now, all of them are in positive territory. None is pointing to an impending recession.
But with P/E ratios at elevated levels—whether you look to trailing, projected, GAAP or operating earnings—I think it makes the market more vulnerable to exogenous shocks, and even though geopolitical events are known events, we really just don’t know how to quantify them. How do you put a geopolitical event into a financial model? So, I think that’s what’s causing investors to sit on their hands.