One of the many market pundits I follow and have high regard for is Sheraz Mian, director of research at Zacks. In his latest newsletter he laid out the arguments for both bullish and bearish camps. Here’s what he had to say.
Bullish Case
The Negatives are Already Priced in: This means that the sum total of all bad or negative news is already well known and reflected in current prices. It seems quite plausible since questions about the Fed, the U.S. economic outlook, China and the Euro-zone’s future have been around for a while now and are no longer ‘news’ to any market participant.
Healthy Economic & Earnings Pictures: The U.S. economy hasn’t displayed much growth lately, but the outlook remains favorable with growth expected to improve from the third quarter onwards. Key indicators of the economy, particularly the labor market, are continuing to improve, which should help offset some of the negative impact from higher interest rates on the housing recovery. The corporate sector is in excellent shape, with total earnings in Q2 on track to reach a new quarterly record and the earnings growth rate expected to ramp up materially later this year.
A Very Supportive Fed: Some questions about the future of the Fed’s QE program notwithstanding, the overall monetary policy stance across all the major economies, including the U.S., remains favorable and supportive of the market. This means that even after the Fed starts ‘tapering’ the QE program later this year, it will continue to keep short-term interest rates at the current near-zero level for a very long time.
Bearish Case
Market is Pricing a Best-Case Scenario: Market prices reflect consensus expectations, and current consensus expectations for GDP and earnings growth are clearly on the optimistic side. Europe’s situation has stabilized a bit, but the region is expected to remain a headwind for the global economy for a long time. The situation isn’t that better in China either, where the best-case scenario is a stable economic growth at rates significantly lower than what we saw in the past decade. The rest of the so-called BRICs appear to have hit a wall as well, which is having knock-on effects all over the world. It is way too optimistic to assume that the U.S. economy and corporate sector will remain immune from the negative forces swirling all around.
Economic & Earnings Pictures Far from Healthy: The U.S. economy is no doubt doing better relative to the rest of the world, but that’s only in relative terms – the rest of the world is doing so much worse. Housing and the labor market are doing better, but GDP growth is unlikely to materially improve from what we have experienced lately. On the earnings front, don’t let the optimistic consensus estimates for the second half of the year and beyond distract you from the fact that the picture is hardly in good shape. Estimates have started coming down already, but have plenty of more room to go. Popular stock market valuation multiples, which the bulls never tire of citing as reflective of under- or fair valuation, start showing otherwise when more reasonable earnings estimates are used.
The Fed is in a Bind: The Fed didn’t provide any fresh guidance on the ‘Taper’ question recently, but the debate itself is reflective of the realization that the program can’t continue forever. Investors have become so accustomed to the Fed pumping liquidity in the market that they see no difference between ‘tapering’ and ‘tightening’. Bernanke’s clarifications and assurances have helped stall the uptrend in long-term interest rates, but they remain elevated relative to where interest rates stood through May. The Fed’s recent inability to effectively communicate its intentions about the QE program is likely a sign of things to come as they move towards unwinding the extraordinary policy of the last few years.
Putting It All Together
Mr. Mian’s Case
As regular readers know, the bearish case makes more sense to me than the alternative. Simply put, I find it hard to envision stocks holding their ground in the current sub-par corporate earnings backdrop. The market hasn’t paid much attention to the persistent negative earnings estimate revisions over the past year or so, likely on the assurance of continued Fed support. But with the Fed on track to get out of the QE business in the not-too-distant future, they have to start paying attention to corporate fundamentals.
My Case
Since I’m a contrarian by nature, I am very nervous and uncomfortable holding stocks at this point. But I’m also driven by a discipline that includes a heavy reliance on the business cycle. Currently the cycle is in growth mode with no recession in sight for at least the next six months. To me that means any corrections will continue to be short and shallow – like the 5% to 10% we’ve seen over the last couple of years.
Anyone who sells now, in anticipation of a larger correction or a full-blown bear market, is getting ahead of the indicators. The probability of guessing correctly on the way out of stocks, and then guessing correctly again on the way back in, is very low. Better to buck up and stay fully invested, no matter how uncomfortable it may be.