Suddenly This Summer: Sell-Off An Omen, Or A Buying Opportunity?

by: Jim Kelleher

Summary

The strongest selling sessions in July came amid above-consensus GDP, a solid jobs report, and continued double-digit EPS growth.

Selling could signal an overvalued market wobbling toward deeper decline, or investors may be anxious to get a moderate correction “out of the way.".

The economic indicators are almost universally positive, and the market perceives that the Fed’s job description may be changing: from stimulator, to rate cop.

For most of the nation, it's been a mild summer with an absence of real scorchers. Maybe it was the cool weather that lulled the market into forgetting its own "sell in May" advice for a two-month span between mid-May and mid-July. The weather hasn't really heated up, but the market sure has. Late-month selling turned July negative; volatility has spiked; and bullish confidence has tanked.

The strongest selling sessions in July came amid above-consensus GDP, a solid jobs report, and continued double-digit EPS growth. There are a couple ways to look at month-end slump. It could be an ominous sign of an overvalued market wobbling toward deeper selling. Or it could be that investors were anxious to get a moderate correction "out of the way" before resuming their bullish proclivities. If the second supposition is true, then the market should be full of buying opportunities.

We are not sure what to make of sentiment, so we'll default to a measurable input: earnings growth. So far in 2014, EPS growth has been run ahead of stock price appreciation. That's helped work off some of 2013's stock-market excess while better aligning valuations with growth prospects. We would use the recent dip to buy high-quality names, while avoiding low-quality, high-beta names that may look cheap but could be value traps.

What the Economy Told Us

The final week of July featured a plethora of data, including the advance reading on 2Q14 GDP growth; the July non-farm payrolls report; calendar 2Q14 earnings from about one-fifth of the companies in the S&P 500; and Fed minutes from the recent FOMC meeting. That latter input is usually open to interpretation. Given the relative inexperience of the new Fed chairperson, along with puts and takes in the employment situation, investors are uncertain how the Fed will proceed. But there is no disputing the positive picture painted by recent economic data and earnings.

On the earnings front, just under four-fifths of S&P 500 companies have reported calendar 2Q14 results; the bulk of "missing' reporters are off-calendar technology and retail companies on a May-July or June-August quarter. As of 8/4/14, 383 companies (77% of the S&P 500) had reported calendar 2Q14 earnings growth totaling 10.7% on a year over year basis. That was better than the market's pre-reporting expectations for 5% growth, and consistent with EPS "beats" in the 400-600 bps range for past 6-8 quarters. Guidance, while typically guarded, has also been better than in recent quarters, signaling that companies see room for expansion in second-half 2014 earnings.

The Department of Commerce's Bureau of Economic Analysis released an advance report of 4.0% growth in 2Q14 GPD, besting consensus expectations in the 3.0%-3.2% range. The BEA also revised up the previously reported 1Q14 GDP decline to -2.1%, from a previous -2.9%. GDP for both periods reflected revisions to national income and product accounts. Highlights for 2Q14 GDP included 2.5% growth in real personal consumption expenditures, after anemic 1.2% growth in 1Q14. Non-residential fixed investment, a proxy for corporate capital spending, surged 5.5% in the quarter from 1.6% in 1Q14. Real exports swung to positive 9.5% growth, following 9.2% contraction in 1Q14. And real private inventories were additive to 2Q14 GDP, after subtracting 116 bps from growth in 1Q14.

Of all those data points, we are most encouraged by the change in non-residential fixed investment. In the years since recession and stock-market collapse, corporations have steadily dedicated cash to share buybacks. But after the 30% stock-market rally in 2013, stocks in many cases are too pricey to justify share repurchases; and companies are now seeking better returns on capital from investing in their own activities. Capital investment is positively correlated not only with jobs growth but with growth in higher-paying, higher-quality jobs.

On the topic of jobs, the U.S. economy added 209,000 jobs in July 2014. Argus President and Economist John Eade noted that the July jobs report "had a little bit of something for everyone." For investors fearful the economy was heating up too fast, the July total marked a slowing from the 12-month trend (214k) and the six-month trend (244k). For investors concerned the economy is not creating enough high-paying jobs, some of the best growth occurred in higher-wage sectors (professional & business services, manufacturing, and construction), while the relatively low-wage retail sector was stagnant.

In July, the unemployment rate edged up 10 basis points, to 6.2%, as more formerly discouraged workers entered the labor force. According to the Federal Open Market Committee (FOMC) minutes release on 7/30/14, "A range of labor-market indicators suggests that there remains significant under-utilization of labor resources." The Fed continues to wind down its quantitative easing program, now at $25 billion and set to expire around October. But that does not mean a rate hike will follow. Fed Chairperson Janet Yellen has emphasized that she is looking well beyond the headline unemployment rate in setting Fed rate policy.

Continued sub-par wage growth and persistent under-employment contribute to the likelihood that the Fed will continue to maintain the Fed Funds rate at or near zero five years after the recession. Average hourly earnings are up about 2% year over year, less than the rate of inflation; in a healthy economy, wages tend to rise 3%-4% annually, Chairperson Yellen has stated. Too many Americans seeking full-time employment are stuck in part-time jobs. Workforce participation of 62.9% is more than 300 bps below its pre-recession levels; and long-term unemployment (more than six months) is at three-times pre-recession levels.

The Fed's New Job

While Fed Chairperson Yellen continues to point to the need for accommodative policy, asset markets show signs of moving on. Once the final QE program runs down in October, the economy will truly be on its own. The economic indicators are almost universally positive, and the market perceives that the Fed's job description may be changing: from stimulator, to rate cop.

The U.S. economy was in nearly unprecedented danger in 2008. But, thanks to underlying strengths in the private economy and significant Fed stimulus, the economy is standing on its own two feet and growing. The Fed chair points to weak underlying unemployment trends as justification for extended low rates. But with mid-duration Treasury yields (2- and 5-year) near three-year highs, investors are signaling that they expect the swing from accommodative to restrictive Fed policy to occur, perhaps as soon as mid-2015.

In its next phase of central bank policy management, the Fed must guard against an over-heating economy where availability of too-cheap money encourages speculative excess and eventually leads to inflation. Sooner than you think, the Fed may need to rely on traditional policy tools. Once the Fed begins to hike the Fed Funds rate and the Discount rate, precedence suggests that there will be a series of such hikes, not one or two, in quarter- or half-point increments.

Conclusion

We are not there yet. We think the economy could actually be in a sweet-heart period where growth is neither too weak nor too rich. After a soft start to the trading year followed by a two-month rally through mid-July, the selling into month's end has brought many stocks right back to where they started the year.

The net impact of economic expansion, growing earnings, and a hesitant stock market is some of the best values in equities we have seen in a year. It takes boldness to invest in the teeth of corroding sentiment. But if investing was easy, we'd all be equally rich (or equally poor). And the best opportunities are available at the worst times.

Repeating our opening observation, we would use the recent dip to buy high-quality names. We would continue to steer clear of rising-tide stocks now sinking back to the shallows based on their poor earnings growth

(Jim Kelleher, CFA, Argus Director of Research)

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.