Concern that the U.S. economy was rapidly decelerating, possibly into a recession, evaporated Friday after the employment report. The stock market rocketed back near to new highs for the year and all the loss from Brexit was behind us. Traders got burned once again and investors, who had excess liquidity, and used market weakness to add to positions were the winners. How perfect was that? The market pundits had egg on their faces once again. It appears that they are always looking through that rear view mirror acting as Monday morning quarterbacks.
While I will caution you not to make any snap decisions based on one data point, bearishness reached a point where at least a quick rally was easy to ignite. However, let me repeat that we continue to see 2.0+% growth for the U.S. economy this year, more for the last three quarters, and the surprise will be that corporate profits will exceed earlier forecasts and that interest rates will be much lower than earlier projected too.
The bottom line is that the market was and still is statistically undervalued. But bearishness and concerns abound, including our Presidential election, restraining the market from reaching its true potentials. Notwithstanding, the market is within striking distance of new highs.
Our interest rates are this low because money flows from abroad are coming across our shores at record levels searching for our yield, even with 10 year Treasuries yielding under 1.4%. The flattening yield curve is NOT a reflection of a weakening economy as many say, but it is demand simply exceeding supply.
When will this end? Only when foreign governments adopt policies for growth so Draghi can refrain from aggressive buying across all debt in Europe and the BOJ moves from a negative rate bias. While I still believe that this will happen as policies for growth are adopted as discussed in last week's blog, it won't happen overnight; so right now we can enjoy the best of both worlds…higher earnings and lower interest rates.
I want to confirm a few of our core beliefs:
The first is that our economy will have lower highs and higher lows in economic activity for reasons mentioned before.
Secondly, that we will have lower inflation and therefore, lower interest rates, in future economic cycles than in the past.
I want to caution you that rates will normalize at higher levels than now over time and the yield curve will return to a more normal slope. In addition, the dollar will remain, longer term, the currency of choice given problems in Europe and Japan, which won't go away overnight.
Risk off has changed the dynamics of the dollar only short term. Finally M & A activity will continue at record levels.
Just a quick mention of the employment numbers reported Friday. The out-sized gain of 287,000 jobs brought the 2-month average to less than 150,000 per month, which is okay, but nothing to write home about. Wage gains, the U-6 level and labor force participation all stayed within bound. Bottom line is that a recession is not imminent nor is a boom economy. Just more of the same meaning 2-2.5% growth, which is fine.
Earnings season begins this week led off by Alcoa (NYSE:AA). I expect that overall corporate earnings will beat expectations for the quarter; most companies will bump up their forecasts slightly for the year but will remain cautious and hold down spending plans despite much higher cash flow; dividends and buybacks will remain a top priority until there is more clarity regarding potential changes in government tax and regulatory policies; and managements will make cautious comments regarding Brexit but are prepared to make any changes needed to preserve profitability. It will be a surprising good earnings season despite what you hear from the pundits.
So where do we come out? Market volatility is moving as much on changes in sentiment as perceived changes in fundamentals. Ironically, fundamentals have not changed as much as the market creating opportunities for investors to add to positions at attractive prices.
Clearly more volatility is here to stay and so investors need to maintain excess liquidity at all times as the market has a way to take down all stocks when there is a downdraft due to electronic systematic trading and a pack mentality. You need to have those core beliefs that serve as a compass in all environments; you need diversification and risk controls and most importantly you need to understand why you own or are short each investment and how each one fits into an overall portfolio. Invest, don't trade.
Remember to review all the facts, step back, pause and reflect, consider mindset changes, maintain excess liquidity with risk controls, do independent research on each investment and…