Market Update: Buying Stocks Because Expectations Are Low

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 |  Includes: DIA, IWM, QQQ, SPY, VXX, XHB
by: Pendulum

The rally in equities on Friday was the product of good news meeting low expectations. As we enter Q3, the market may be positioned for this theme to play out on a larger scale. Macro concerns, bad news and underwhelming economic numbers have caused investors, analysts, companies and the Federal Reserve to reduce their growth projections. As this has been happening the market experienced a 10% correction, but, significantly, did not meltdown and has recovered from its recent lows. Investors have had a lot of time to factor the bad news into their game plans, but the one thing that has been absent from the conversation is the potential for good news. It is important to remember that bad times will be followed by good times and good times turn into bad times. When we are immersed in a bad period, but no major crisis emerges, we prefer to position our portfolios for an upturn. For much of Q2 we sat on the sidelines with a large cash position, but as we enter Q3 we are increasing our long exposure and buying stocks because expectations are low and positive catalysts could come from a number of places.

In this week's update we give a broader view of investors' low expectations. We will then discuss the S&P 500 (NYSEARCA:SPY) and other major indices and the "Risk On / Risk Off" indicators. Finally, we will present the bullish and bearish cases and our updated investment plan.

The Beauty Of Low Expectations

Expectations on multiple fronts have come down over the last few months. Even after the EU summit on Friday there are still low expectations about the situation in Europe. The consensus seems to be that the eurozone mess will be with us for many years. Furthermore, the slow economic growth in Europe, and recessions in some European countries, will be a drag on US corporations with European exposure.

In addition to low expectations about the prospects of Europe, there is increasing chatter about the prospects of slower growth in China. The cover story in Barron's this week is "Falling Star" about the slowdown in China. Barron's writes, "The Chinese economy is slowing and is likely to slow a lot more. Get ready for a hard landing."

While China has problems, it still has an economy that is growing at an exceptional rate. Annual growth of 7-8% may disappoint investors, but it is still enviable. Furthermore, the recent decision to cut rates in China signals that the government wants to avoid a slowdown and it still has many tools to boost growth.

Growth estimates for the US economy have also been coming down. The WSJ recently summarizes the Federal Reserve's update economic projections (Fed Lowers 2012 Growth Forecast; Sees Higher Jobless Rate, Lower Inflation):

The Fed's "central tendency" for the U.S. gross domestic product now ranges from 1.9% to 2.4% this year, compared with the 2.4% to 2.9% gain predicted in April. Growth is seen between 2.2% and 2.8% in 2013, from the April view of 2.7% to 3.1%. U.S. GDP growth is seen between 3.0% to 3.5% in 2014. The Fed's outlook on hiring was also gloomier. It now sees the unemployment rate this year as coming in between 8.0% to 8.2%, from April's projection of 7.8% to 8.0%. Next year the Fed sees the unemployment rate coming in between 7.5% to 8.0%, versus April's projection of 7.3% to 7.7%. The Fed's 2014 unemployment forecast is 7.0% to 7.7%.

It seems that analysts have been lowering their earnings expectations as well. Ed Yardeni writes (S&P 500 Forward Earnings):

The next earnings season is about to begin. Industry analysts have been curbing their enthusiasm for Q2-2012 results since the end of Q1. They've lowered their S&P 500 estimate for the current quarter from $26.11 during the week of March 30 to $25.38 during the week of June 21. That would put the quarter up only 5.2% y/y, the weakest since the end of the recession. Over the same period, they've also cut their estimates for Q3 and Q4.

Although earnings expectations are coming down, the numbers may be reduced further. It seems that every day there is news about companies reducing their guidance or missing their numbers.

On the political level, the upcoming Fiscal Cliff is a major risk for equity investors. It seems that there are low expectations as the eventual solution will likely include higher taxes, less government spending or a larger deficit. Furthermore, the road to eventual disappointment will entail lots of unnecessary political brinkmanship.

Potential For Positive Catalysts

In order to transform low expectations into equity gains, positive catalysts need to emerge. We think that there could be a number of positive catalysts in the weeks and months ahead.

Housing has been one area of the economy that has been a source of good news in the otherwise gloomy environment over the last few weeks. Bloomberg reports (Home Sales Reach Two-Year High As U.S. Rates Fall: Economy):

In response to improving demand, builders broke ground on 516,000 single-family houses last month at an annual pace, up 3.2 percent from April and the most this year, the Commerce Department reported last week.

The pick-up in new home construction is important since the housing sector is a big employer and increasing construction has positive consequences on many related companies and industries. We cannot predict if housing has bottomed, but it seems that there is more upside potential in housing than downside. For the last few years, as Bloomberg reports, housing has been weighing down the economy, but that may be changing:

Residential construction hasn't contributed to economic growth over the course of an entire year since 2005, when it accounted for 0.4 percentage point of the 3.1 percent increase in gross domestic product. From 2006 through 2009, the homebuilding slump subtracted 0.8 percent point from growth on average. The declines diminished over the past two years.

The stocks of home builders have outperformed the market so far this year. The following chart compares the price movements in the SPDR S&P Homebuilders ETF (NYSEARCA:XHB) with the SPDR S&P 500 ETF , which is marked in yellow.

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(Source for charts, unless otherwise noted: FreeStockCharts.com)

Another potential catalysts could be the Federal Reserve. The Fed's recent decision to extend Operation Twist and leave open the possibility of further quantitative easing indicates that the Fed will backstop the equity markets as long as unemployment remains high and economic growth remains low. Although it is increasingly harder for the Fed to boost the economy, the fact that the Fed seems willing to step in if needed could be enough for equity investors. At several points over the last few years, it has paid off to go long equities on the belief that either the economy will improve or the Fed will take further action to assist it. We may be at a similar point now.

Finally, all the pessimism could be overblown and the economy may pick up after a few slow months on its own.

S&P 500 and Other Major Indices

Following the large gain on Friday, the S&P 500 ended the week at 1,362. The 1,360 level is significant because it was the top end of the trading range last summer and the bottom end of the trading range in March, April and May. The following charts show the S&P 500 on a YTD and 52 week basis.

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With the S&P 500 at the crossroads represented by the 1,360 level it will be interesting to see how the market reacts to the upcoming earnings season. Trading next week will be interrupted by the July 4 holiday and volumes will likely be low. However, the following week will include the Q2 earnings release of Alcoa (NYSE:AA), which represents the start of Q2 earnings season. Q1 Earnings seemed to be a catalyst for declines in the S&P 500, after the market rallied through the previous two earnings season.

There have been a lot of negative pre-announcements and reductions in analysts projections. This trend will likely continue. It will be interesting to see if the market remains resilient through earnings season by staying above 1,360 in the S&P 500.

The price movements in the Dow Jones Industrials Average (NYSEARCA:DIA), Nasdaq (NASDAQ:QQQ) and Russell 2000 (NYSEARCA:IWM) were similar to the S&P 500. However, it is interesting to note the move in the Russell 2000 on Friday. Out of the four major indices, the Russell 2000 advanced the most above the June 19-20 highs. In prior updates we noted that the Russell 2000 seemed to be lagging the S&P 500 and the Dow Jones Industrials Average. It would be bullish for the overall market if the Russell 2000, which contains small stocks, continues its move and outpaces the other indices.

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Risk On / Risk Off Indicators

Last week we mentioned that the Risk Off trade seemed to be unraveling and Friday's action was a clear Risk On move. Despite the impressive Risk On action on Friday, we are still monitoring the Spanish and Italian 10 year bond yields. The Spanish 10 year bond yield closed the week at 6.329% and the Italian 10 year bond yield closed the week at 5.819%. We would like to see both sustain a move below 6% as confirmation that investors are moving on from the recent concerns about the European situation, at least for the short term.

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(Source: Bloomberg.com)

Like the equity markets, the price of oil increased dramatically on Friday. WTI Cushing Crude Oil closed the week at $84.96 per barrel. Oil had been declining based on the perception of weak demand from slowing developed and emerging economies. However, after a large drop since the beginning of May, the price of oil may be halting its decline in the $80 range. We expect that Q2 earnings of energy companies will likely disappoint and many companies will reduce guidance going forward. However, if the price of oil can halt its decline, there may be interesting opportunities in the sector.

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(Source: Bloomberg.com)

Finally, the VIX - CBOE Volatility Index ((NYSEARCA:VXX)) closed the week at 17.07, below the significant 20 level. The decline in the VIX is a bullish indicator. If the VIX continues its decline we may add positions that are long volatility to hedge against a future decline in equities.

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The Bull Case

The Bull Case for the coming quarter calls for a continued move higher based on the temporary end of the current round of the European crisis. The market may decline a bit in the short term following the big jump on Friday. However, now that investors have been lowering their expectations for Q2 earnings following months of bad news, the upcoming earnings season could act as a catalyst for market gains. In the absence of a major crisis, the combination of low expectations, cheap valuations and Federal Reserve backing could be positive for the equity markets.

The Bear Case

Although we had a lot of optimism on Friday, the S&P 500 is sitting at the key 1,360 level and it may have trouble sustaining a move higher. Although expectations are low, they could move even lower before things turn around. Many companies will likely reduce their guidance for the second half of the year in the coming weeks and Q2 earnings could disappoint investors.

There are still several macro concerns. Although European leaders may have kicked the can down the road, Europe is still a mess and it will take years to fix. Furthermore, the Fiscal Cliff and US elections could cause the equity markets to decline. Finally, the China bears may be right about the slowdown in China, thereby depriving the global economy of a key engine of growth.

Investment Plan

We recognize the bearish concerns about the economy and the equity markets, but we are planning to increase our long exposure in the coming weeks.

From a short term tactical perspective we want to see if there is upside confirmation of Friday's large move in the equity markets to determine the timing and pace of our purchases.

As we mentioned last week, we think that the S&P 500 may continue to trade in the range between 1,265 and 1,420. In such a scenario we think there will be good opportunities when the S&P 500 is in the low/mid 1,300 range. We think that the S&P 500 will reach the top of the range in the next few months. We are not yet sure if the S&P 500 will break above the 1,420 level and we will assess those odds if and when the S&P 500 gets there.

We are focusing on several types of investment opportunities, including high beta stocks that suffered during the recent Risk Off declines, technology stocks and energy stocks.

Despite our increasing conviction to add to our long exposure, we will maintain our strategy of employing strict stops to prevent large declines. Considering the numerous risks that equity investors face, we want to limit our losses in case we are wrong.

Disclosure: We have positions in the ProShares Short QQQ ETF (NYSEARCA:PSQ). We may trade this positions or the stocks/ETFs mentioned in the article in the next 72 hours.