Earnings season is nearly behind us, and results were unambiguously positive. According to S&P’s web site, 85% of the companies in the S&P 500 have already reported results for the first quarter. Of that 85%, roughly 67% beat analysts’ expectations and just 23% missed expectations. This is considered a pretty good rate of outperformance, and investors reacted with tentative enthusiasm. More recently, however, we have started to see increased stock market volatility. And perhaps more ominous than the volatility may be the fact that stocks have begun to trade with a high degree of correlation again. High correlation means that stocks are generally trading either up or down in tandem. This tells me that investors are trading based on factors other than individual company fundamentals.
The most obvious risk factor is Europe. Recent elections in Greece and France point to an emphatic rejection of austerity measures. The collapse of the government in Holland told us the same thing. Europeans are simply rejecting the notion that they must accept these cuts in government spending (along with tax increases, in many cases). This response strikes me as similar to Steve Jobs fighting his cancer diagnosis with carrot juice and yoga. Rather than accept the tough and required medicine, many Europeans believe they can treat the disease with less painful and invasive methods. But the markets are telling us otherwise. Sovereign bond yields have begun rising again. The yield on the Spanish 10-year is at its highs for the year. Spain is a much, much bigger and more important economy than Greece. And yields on Grecian debt, for that matter, have surged to post-restructuring highs. Apparently the 50% haircuts (the losses Greek bondholders recently accepted as part of the country’s restructuring) may not have been enough. Many are talking about Greece’s exit from the European monetary union as a foregone conclusion at this point.
An article posted on Bloomberg this morning discusses the possibility of additional action by the Federal Reserve. The article says that both Bill Gross (manager of the Pimco Total Return Fund) and Jan Hatzius (Chief Economist at Goldman Sachs) “predicted on the same day (yesterday) that the Fed will announce additional monetary easing when it meets in June.” The rationale for such action will be the sub-par 1Q GDP report, the poor April jobs report, the deteriorating situation in Europe, and, undoubtedly, the recent volatility in the equity markets. We agree with that the Fed will probably be back for more. The Fed is simply unwilling or incapable of standing idly by as stock investors lose money. Bill Gross said it best when he said, “Risk markets (ie, stocks) need more ammo if they are to stay up.” And indeed Bernanke has made it clear that he wants higher stock prices. This type of thinking continues to worry us. We are more inclined to agree with Richmond Fed President Jeffrey Lacker, who believes that additional monetary stimulus would be ineffective and risky. Lacker said on Monday, “Some commentators are urging the Fed to take additional action as long as the unemployment rate remains elevated. But if elevated unemployment reflects largely fundamental factors rather than insufficient spending, such stimulus might have little impact on unemployment and instead just raise the risk of pushing inflation up.”
In my opinion, policymakers (and investors) have to consider the possibility that stocks fluctuate. Stock investors are always looking ahead to the future, and now is no different. Now that earnings season is in the rearview mirror, investors want to know, “What have you done for me lately?” This strikes us as the typical noise that investors need to ignore in order to be successful. Is it possible that stocks had gotten ahead of themselves since the beginning of the year as a mild case of irrational exuberance set in? Yes, this is quite possible. But it should also be recognized that there was a large degree of investor skepticism all year long as the S&P 500 worked its way to gains of over 10%. The point is that nobody can effectively predict short-term market moves with any degree of precision. Numerous studies have shown that long-term returns can be severely impacted if investors miss just a few of the best-performing days in the market cycle. Therefore, the most successful investors remain invested and try to drown out the noise.
Earnings season provided further evidence that corporate fundamentals are actually quite good. But not all is rosy, as we have tried to hammer home over the past several months. Historically high margins are leading to a healthy amount of skepticism about future earnings growth, keeping the bulls in check. At the same time, there are several large exogenous risks, including Europe, the fiscal cliff, and the Fed’s need to unwind monetary policy. And finally, consumers and governments must continue down the long road of balance sheet repair. Most of these issues cannot be addressed through monetary policy. Therefore, it makes most sense to us that the Fed stand pat for now. And it makes most sense for investors to assume that the slow-growth environment continues. It certainly does not make sense to swing for the fences right now. Stick with high-quality, blue chip companies with strong balance sheets.