Nicholas Colas is a managing director and chief market strategist at brokerage ConvergEx Group. Previously he worked in equity research at Rochdale Securities and investment bank Credit Suisse First Boston.
Harlan Levy: Is the stock market swoon the start of a correction, and are stocks overvalued?
Nick Colas: The bottom line is that it appears to be a normal correction. Stocks are probably closer to fairly valued than they are undervalued, and you have incrementally less liquidity from the Federal Reserve, which at this point in the economic cycle is an important data point that does affect stock prices.
We've had a abnormally low volatility over the course of the past at least year and, relatively speaking, for the past five years, and as a result we do have to have some reversion to the mean in actual market volatility, and that's what we're seeing right now.
Q: How long do you think it will continue?
A: I think we're going to be living with this for at least the first half of earnings season, because we have to address corporate earnings and corporate expectations for profits for the balance of the year, so I would peg this at least lasting for two more weeks, and possibly three.
Q: What do you expect for earnings?
A: Corporate America has done a fantastic job of generating high levels of profitability in a very slow economic cycle, so I don't worry that profits will fall out of bed. But I do worry that revenue growth won't be where analysts want it to be, and I worry even more that revenue expectations are still too high.
Q: Do you think the Federal Reserve will continue to taper back its monthly purchases of Treasury bonds and mortgage-backed securities or might it pause a bit?
A: It would take something fairly extraordinary for the Fed to change course at this point on its reduction of quantitative easing. The bottom line is the Fed has to get back to a more normal base of policy as quickly as possible. Reducing QE is the most important feature of that plan.
Q: When do you think QE will end?
A: It should be over by the very end of this year or at the very latest at the beginning of next year, and I think it's necessary.
The Fed did a lot of heavy lifting. There are many people probably reading this interview who don't like what the Fed stands for, but there's no arguing that they did a lot of work over the past five years to stabilize a very fragile economic and financial system. And they did it with a lot of extraordinary measures which aren't appropriate for the current environment, so it's correct that they back away from them.
Q: How do you analyze the economy?
A: We're looking at Gross Domestic Product growth of 2.5 percent, the best-case scenario. There had been a lot of real hope that we could get back to 3.5 or 4 percent in the back half of the year, but that doesn't seem likely at this point.
Many people use weather as an excuse for first-quarter performance, and I take that with a grain of salt, because winter comes every year. At the same time I do get the fact that it's a little bit harder to read the economy right now based on the current data, so that adds a layer of uncertainty to the market's assessments, evaluations, and growth to the back half.
Q: What do you think of the job situation?
A: I am actually optimistic about the employment situation in the U.S. than most. We look at tax receipts from the Treasury to ascertain how strong the labor market is. Obviously, if more people are working, then wages are going up, and taxes would be going up. And year-over-year tax withholding receipts to the Treasury right now are running about 8 or 9 percent higher than the prior year. So even though the jobs numbers show a weak story - and I don't think anyone would argue with that - the underlying data, the income data as reflected by tax data is a little bit better, which tells me that the underlying strength of the labor market is perhaps a touch better than people realize.
Q: What kind of monthly job creation numbers do you see?
A: At this point in a recovery they should be much higher than we are, but I would be looking for numbers more to 200,000 for at least the next three months.
Q: What do you think of housing, which must stay in a recovery mode to sustain the economy?
A: I worry about housing. I may be a little more optimistic about the labor market than most, but I'm a little more pessimistic on housing than most. I worry that the snapback in pricing that we got over the past few years was based on investors purchasing houses to fix them up and rent them and not on organic demand from the homeowners themselves. We'll see very soon, because interest rates have fallen again, and if mortgage markets don't pick up, we'll find that house prices will basically going to be stagnant for the next few years, because low interest rates should improve demand, yet we're seeing declining mortgage applications instead.
Q: What do you think of the bond market?
A: The bond market is a trade the world got wrong this year. We began the year at 3.03percent on the 10-year U.S. Treasury, and as I look at my screen we're at 2.62.
The only thing everyone agreed on at the beginning of 2014 was that yields were going higher, and I was absolutely wrong.
I have perceived this move in rates as more of a risk-off asset reallocation trade, people taking money off the table in equities, putting it into bonds to lock in their gains. That's why you had a good bid for bonds this year.
However, there's an alternative narrative shaping up. That is that the U.S. economy is weaker than we appreciate, and we're going to have a slowdown and possibly a recession in the back half of this year. People worry that the very low levels of bond bids and Treasury yields indicate that that is what the bond market is discounting, a very, very worrisome observation.
The concern that investors are beginning to have, and I only started hearing this last week from clients is perhaps the bond market is beginning to discount a recession, in which case obviously equities have a long way to go down. It is not the base case for equities at all.
Q: What do you think about China?
A: It's always hard to have a firm grasp on what's actually occurring. I don't doubt the financial system is undergoing a lot of stress. On the plus side, the government seems to understand that. We are basically hoping for some kind of soft landing in China that doesn't involve a deep financial crisis or an erosion of public confidence in the financial system, We've definitely read headlines about both of those topics in the past month. The only thing I watch for is if they get a lot worse.
I think it will be a soft landing, because it's still a demand economy, but you can certainly paint picture it will have a hard landing, based on the very high levels of leverage involved in the parts of the financial system.
Q: What do you think of Europe where inflation is very low?
A: It's absolutely the most important topic related to European markets and a primary issue is deflation. No country, no region wants to be the next Japan, because once you allow deflation to take hold you create all kinds of disincentives, and when you overlay deflation with an aging workforce and a retiring workforce, which big chunks of Europe have, Italy being the most obvious example, you get Japan. And nobody wants to go there.
Frankly, I worry about inflation in the U.S. on many points where it's heading in the wrong direction as well. But in Europe it appears to be more of an immediate problem.
The one relatively good think about the deflation worry is that there's a pretty recognized central bank playbook for addressing it. It's called quantitative easing. So if they do go down that path, there is a page in the playbook to address it, whether they choose to run the play or not is up to them. But it won't be for a lack of experience or lack of an approvable case study for how to address it.
Q: What about the threats that Russia poses?
A: Obviously, Ukraine is at the very top of the list of geopolitical issues that investors need to focus on. Unfortunately, it's one of these opaque issues. As difficult as China is to assess financially, it's equally difficult to address Russia geopolitically, because you don't really know what is in Vladimir Putin's head or what his goals are. He achieved the big one in taking Crimea back. That assures his warm-water port and his naval presence in the Mediterranean. However, we don't know how much further he wants to go. And I don't think \anyone can reliably say that they know what's going to happen or have enough sources in his inner circle to have an edge.
Q: A lot of the issues with Russia involve oil, don't they?
A: We've been talking about oil internally here at ConvergEx, because many investors look at oil as a backhanded proxy for a bunch of different issues, most importantly, is how China is doing. China imports a lot of energy, and everybody looks at oil as a barometer of whether China's economic growth is increasing or decreasing. We've all been surprised to see it stay over $100 a barrel, because if china really is slowing, the demand there should be declining, and oil prices should be declining as well.
There is speculation that oil would be at $75 a barrel or lower this summer. That doesn't seem to be happening, and that's clearly because of Russia. Frankly, the $100 line has another feature to it, which is that over $100 a barrel it begins to be an issue for the U.S. consumer, because it's effectively a tax. If you get one more leg in geopolitical risk in oil and it goes to $140, then you're right back where you were before the financial crisis.
But we're a long way from $140. It would take a geopolitical shock. It's possible, but it doesn't really serve anybody's interests.
Q: Isn't it possible that the U.S. ability to export natural gas and oil could undercut what Putin is doing?
A: I think it's one of those policy decisions that gets put on the table when we get geopolitical risk. It would be great for the U.S. economy to be an energy exporter again. I'd rate it 50-50 in the case of a geopolitical shock, and much less than that if there wasn't one.
Q: How much of an impediment to growth is what's happening in Congress?
A: That's a very well=-phrased question. There's a consensus viewpoint on Wall Street that gridlock in Washington is good for the market. That's probably true under normal circumstances, but we're still trying to recover from a very large financial shock and a very sizeable recession, so I'm not much enamored of the notion that a do-nothing Congress is good for the stock market.
It would be better for the country and for the market if we had a more coherent long-term economic growth strategy, export strategy, energy policy, and I could probably list four or five other factors which would be better for the country if Congress develops long-term plans.
But does it have an immediate effect on P/E ratios, or earnings multiples, or earnings levels? Probably not. But it would probably be on the very top of my "nice to have" list.
Q: What are the chances of Congress doing that?
A: The chance of that happening is about as high as Congress's approval rating.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.