Sam Stovall: Market Volatility Here to Stay for the Near Term

by: Harlan Levy

Sam Stovall is chief investment strategist at Standard & Poor’s Equity Research as well as the author of The Seven Rules of Wall Street and the column Stovall's Sector Watch.

Harlan Levy: How is earnings season going?

SS: Earnings season seems to be going fairly well. But then it was expected to be pretty good. S&P equity analysts were calling for a 44 percent year-over-year in operating earnings, and so far, if you combine actual results with remaining estimates, meaning those companies that have reported and those that are yet to report, the year-over-year gain would be more like 45 percent.

All 10 sectors in the S&P 500 are projected to show year-over-year increases with leadership coming from the financials, materials, energy, and the tech sector. The smallest gains are likely to come from consumer staples, telecommunications services, and utilities.

While earnings have come in better than expected, the only fly in the ointment seems to be revenue growth. Analysts were hoping that an improvement in sales would materialize, since we are a year into this economic recovery. Revenue growth is obviously positive, just not as positive as some were hoping. We’ll see how the rest of the reporting season goes, however.

H.L.: Federal Reserve chief Ben Bernanke said the economy was "unusually uncertain," interpreted by some as meaning a return to recession is possible. Do you agree, and when do you see a solid recovery?

S.S.: We agree that the risk of a double-dip recession has increased. We thought it was about 20 percent. Now we give it a 25 percent possibility. But we also believe that this economic recovery will be a half-speed recovery at best.


We are looking for real Gross Domestic Product growth of 3.1 percent this year versus the more normal 7 percent that you see in the first year of an economic recovery. We think that the consumer remains a wild card, and even though we expect consumer spending to rise 2.4 percent this year, we still see it held back by high debt levels and high unemployment levels.

Consumers will likely maintain their elevated savings rate, currently at 4 percent, in order to pay off these high debts, and because of the lackluster economic growth we see, we project unemployment to average 9.7 percent this year and 9.3 percent next year.

One good thing that could come of this is the lack of inflationary pressures in our opinion. Also, because of the uncertainty surrounding economic growth, we don’t see the Federal Reserve raising interest rates until the second quarter of next year.

H.L.: I gather you don’t see us getting into a devastating deflationary situation with the persistently high continuing jobless claims and job loss numbers, the anemic consumer spending, and weak consumer confidence.

S.S.: All of these factors point to reasons why the Fed is concerned about economic growth and is very willing to keep interest rates at stimulative levels. We know how to fight inflation, but we haven’t been forced to fight deflation since the 1930s, so I don’t think they want to test their aged deflation-fighting acumen.

H.L.: The Republicans in Congress want to cut the deficit dramatically now. Is that a bad idea that might lead to deflation?

S.S.:
S&P as well as the president as well as Bernanke and Treasury Secretary Geithner believe it is a very fine line that needs to be walked between stimulus and deficit reduction. As I mentioned before, the economy is growing at a rate that is only half that it normally experiences. Even then we find that many of the consumer-oriented economic indicators, such as housing and autos, were much more dependent on government stimulus than we thought. I think everyone agrees that we will need to reduce our record level of debt, also a record as a percent of GDP.

The only question is how quickly do we do it. If we attempt to reduced the debt too quickly, that could derail an expansion that has barely gotten started. Yet if we allow the debt to expand or even just remain as elevated as it is, the debt financing could crowd out the use of funds for more expansionary opportunities.

So that’s why I believe the government is ending the stimulus first and watching the response before aggressively cutting back on the debt.

H.L.: With the global economy still shaky with the debt problems of Ireland, Portugal, Italy, Greece, and Spain, are things improving?


S.S.:
First off, we believe that a Greek default is not a "fait accompli." The country will certainly will have to go through a lot of belt-tightening, not only to simply maintain this debt level, but also to reduce it. We don’t think Greece will see the 2008 GDP level until 2017, but it appears as if the International Monetary Fund and the European Union bail-out was enough to stem the near-term tide. The longer-term question remains uncertain.

The other countries, Spain, Portugal, and even non-EU country Hungary, have debt issues that need to be resolved in order to circumvent a potential debt crisis. By monitoring the sale of sovereign debt one can see whether these countries are regaining the confidence of investors. So far they have.

H.L.: Do you foresee the same kind of wild volatility ahead in the stock market?

SS: Sure. I believe that the extreme level of volatility is here to stay at least over the near term as a result of computerized day trading and hedge funds, and exchange-traded funds that magnify either long or short positions in the market, which tends to add to overall volatility.

Disclosure: No positions