Wednesday, May 26, 2010

A Stock Market Correction Hanging In The Balance

Stock market corrections, such as the one we are currently experiencing, are healthy processes by which excesses generated in the advance can be wrung out and rotational (sector) change can evolve. In the process, new leadership emerges thereby helping to elevate the renewed rally to higher levels. There is, however, another evolutionary factor that investors should be mindful of: a correction that could easily evolve into a transitional phase resulting in a market reversal.

One way this transitional phase can occur is when a market correction is succeeded by a failing rally which then morphs into a distributional range from which more market weakness is developed culminating in a market reversal. I referenced one such version of this in last week’s post (“37.17”). While this process is underway, those in favor of the preceding market trend (in this case, a bullish one) argue for a continuation of the preceding good times. In the process, further distributional market action occurs. And when the market decline begins in earnest, the market believers continue to dismiss the move.

Will this occur in the current market conditions? It is too early to say for certain, but for the moment the benefit of the doubt must be given to the bull case for the following reasons:

The fundamental argument for a resumption of the bull after the correction is anchored in optimistic earnings growth levels (S&P 500 operating earnings of $80 and $88 for 2010 and 2011, respectively) coming to pass AND for average to above average P/E ratios (15 to 18) being applied to such earnings. For both issues to occur, an economic slowdown in the US and Europe coupled with a only modest decline in China’s growth rate is one key ingredient*. A second ingredient is for little to no serious surprises in the geo political realm. This would include any exogenous shocks, such as a massive terrorism act. It would also include governments that are overly fractured due to the consequences of domestic politics (e.g. the US mid term elections).

A third ingredient would be for longer-term interest rates (5 and 10 years) to remain range bound and neither decline nor increase substantially as either move would imply deflation or inflation. Both will likely be most unacceptable to investors – the former for the implications of a collapsing pricing structure for businesses (not to mention the risks to monetary policy, among other risks), the latter for the implications of a higher cost of capital (among other factors, and not excluding the possibility of a stagflationary environment).

A fourth ingredient has to be the unforeseen and unintended consequences emanating from the final financial regulatory reform bill and/or overly aggressive action by the regulators. Since virtually no one can predict how far the financial tentacles reach from financial innovation products and processes into the real economy, this is a substantial unknown that goes far beyond just the financial services industry and must not produce yet another macro financial services industry surprise (that ends up negatively impacting the real economy).

In sum:

• Sustained economic growth (albeit at very low rates in developed economies)
• No geo political or exogenous shocks
• Stable longer-term interest rates
• No unintended consequences from the new regulatory regime

If any of the above four items fail to live up to expectations, the fundamental arguments for a resumption of the bull market must be reexamined.

Investment Strategy Implications

When it comes to stocks, it must be assumed that the old Yogi Berra adage, “It ain’t over ‘til it’s over”, applies. The above four items could deliver and the current market correction will be all she wrote. Markets get in gear again and higher highs are confirmed. However, if any of the above falls short, the fundamental justification for higher stock prices is in jeopardy.

From a market intelligence perspective, until there are clear signs of a market reversal (a Mega Trend reversal being the most significant), it is advisable to operate on the assumption that the correction will be just that – a correction – followed by a resumption of the trend in force. That said, investors are advised to be ever vigilant for signs of market deterioration and the aforementioned items as the fundamental story hangs in the balance. And that goes a long way toward explaining the contradictory and conflicting market action of late.

*China's growth must also evolve to a more demand driven model and away from fixed investment and exports, both of which are unsustainable for China and, importantly, the global growth story. Corporate profitability needs to remain at their current levels, something that appears to be quite achievable.

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