BlackRock's Weekly Investment Commentary from Bob Doll, Vice Chairman and Chief Equity Strategist for the week of Aug. 23
Equity markets were mixed to down last week; the Dow Jones Industrial Average lost 0.9% to fall to 10,214, the S&P 500 Index lost 0.7% to fall to 1,072 and the Nasdaq Composite rose 0.3% to reach 2,180.
Economic data continues to point to a US economy that is struggling, but slowly recovering. One noticeable bright spot continues to be corporate earnings. The second-quarter earnings season is nearly complete and, on average, corporations have beaten expectations by an impressive 10%. Overall, 75% of companies have reported better-than-expected results. Non-financial corporate profits have grown by approximately 40% in the second quarter compared to 2009 and revenue growth has also been impressive. As a sign that improvements in corporate earnings have been broad-based, all ten sectors of the market are showing positive gains for the first time since the second quarter of 2007.
Perhaps the most important data points regarding the strength of the economy are those regarding the employment landscape. Gains in employment are a necessary catalyst to spark a self-sustaining economic recovery. The overall trend in employment growth so far in 2010 has been positive, but gains have been small and have not been enough to lower the unemployment rate. The latest figures on this front were last week’s initial jobless claims, which increased again, reaching 500,000 for the first time since November 2009.
The continued weakness of employment data and other areas of the economy remains a concern, with many believing that the United States is in a process of sliding back into recession. This fear has held stock prices back despite strong corporate earnings. To be sure, if the United States does enter into recession again, there will be a corresponding drop in stock prices. However, even without such a scenario, there is enough prevailing uncertainty to keep investors on-edge. Consumers and investors remain uneasy, and we have seen an increase in the household savings rate, which naturally corresponds with a decrease in consumer spending levels. The corporate sector remains an important counterbalance, with rising profit margins, low borrowing costs and healthy balance sheets.
Looking ahead, we believe that economic data will continue to be mixed and that disappointments will continue. In any case, however, we have not altered our view that the economic recovery will continue; we do not believe that the economy will endure a double-dip recession. Growth levels should remain positive for the time being, although the pace of growth will be slower than that typically associated with recoveries.
The sell-off in stock prices since mid-April is primarily a reflection of the markets’ discounting of the slower trend in economic growth. If our forecast holds true, however, and we are enduring a soft patch rather than a renewed recession, stock prices should soon stabilize. The prevailing crosscurrents are likely to mean that we will endure a prolonged stalemate for equities. As long as employment growth is sluggish and the consumer sector remains depressed, we are unlikely to see a quick rebound in equity prices. On the other hand, strong corporate profits and extremely low interest rates have created attractive equity valuations, which should keep buyers in the marketplace.
The sharp pullback in bond yields throughout the past couple of weeks suggests that fixed income markets are discounting a return to recession conditions. In contrast, the relative resilience of the stock market suggests that equities are discounting a milder slowdown in the pace of recovery. If the bond market is correct, stocks will almost certainly fall further throughout the course of 2010. However, if the bond market is wrong and the equity market is correct, then we should see a backup in yields and greater resiliency in the stock market. We believe that fixed income markets are overly pessimistic, but acknowledge that it will take some time to work all of this out, meaning that stocks are likely to remain in a trading range.
Number to Watch: Forward Earnings, From David Rosenberg, chief investment strategist, Gluskin Sheff
It must be extremely frustrating for the bulls to see the market down 12% from the April peak even with 12-month trailing EPS rising 18% since then.
So what’s changed for the worse?
The answer is analyst earnings revisions. The Thomson IBES 12-month forward earnings estimates have been trimmed more than 7%, to $87.89 from $94.79 back in April. Come to think of it, the peak in earnings forecasts coincided with the peak in the market.
And guess what? The forecast peak in the last cycle was in October 2007, again right when the S&P 500 was hitting its highs. Before that, earnings estimates were starting to get cut in August 2000, just ahead of the peak in the market.
If you are just watching the earnings themselves, on average they are off six months from the time the stock market rolls off the peak. Earnings estimates seem to be a perfectly good timing device.
The same holds true at bottoms. Forward estimates hit their trough in March 2009 right at the same time the market bounced off the lows. If you waited for the actual earnings to revive, which they did in November 2009, you would have missed eight months of 65% gains in the S&P 500.
Go back to the cycle before that one and you will see that earnings forecasts only began to rise in January 2003 — right when the equity market was carving out a bottom. If you decided to jump in when actual earnings bottomed, which was much earlier at December 2001, you would have been clocked by the huge correction that occurred just under a year later.
The Number to Watch: Mutual Fund Flows, from Charles Biderman, CEO, TrimTabs
The Aug. 11 issue of TrimTabs Weekly Flow Report shows that mutual fund flows are a good leading contrary indicator of returns for roughly half of fund categories. The August 18 issue expands on the concept and introduces trading strategies designed to capitalize on bouts of retail exuberance and misery.
We believe separating mutual fund flows into ¨Dreturn-chasing¡¬ and ¨Dresidual¡¬ components benefits investors because the latter contains the most valuable information about retail sentiment. We hypothesized that residual flows are a good short-term momentum indicator and a good long-term contrary indicator.
Below are the key findings of our study, which is based on our mutual fund dataset. We track the flows, assets, and net asset values of nearly 6,000 mutual funds with combined assets of $1 trillion on a daily basis.
• The relationship between residual flows and returns has the expected shape. Strategies with positive residual flows deliver excess returns in the short term but underperform in the long term, while strategies with negative residual flows underperform in the short term but outperform in the long term.
• A portfolio investing in the mutual fund categories with the largest positive or least negative residual flows in the past 30 days—our short-term momentum portfolio—delivered an excess return of 76% in the past decade. The Global Real Estate category is currently this model’s best bet.
• A portfolio investing in the strategies with the largest negative (or least positive) residual flows in the past 270 days—our long-term contrarian portfolio—delivered an excess return of 82% in the past decade. The Mid-Cap Value category is currently this model’s best bet.
Monday, August 23: Chicago Fed National Activity Index (July)
Tuesday, August 24: Retail Sales (weekly), Existing Home Sales (July)
Wednesday, August 25: Mortgage Applications (weekly), Durable Goods Orders (July), New Home Sales (July), FHFA House Price Index (June)
Thursday, August 26: Jobless Claims (weekly), Money Supply (weekly)
Friday, August 27: GDP (second quarter), Corporate Profits (second quarter), Reuters/University of Michigan Consumer Sentiment Index (August)