With the stock market looking stronger in recent days, it’s a good time to ask the question that’s on every investors mind: Have we seen the lows for this year? Last Friday’s decent but not great jobs report is the most recent of a string of positive headlines for those who are in the bullish camp. But stocks were already moving up before the labor market reading. Bold rhetoric from Mario Draghi, head of the European Central Bank, has also been stoking expectations that the ECB may be on the verge of getting a handle on the sovereign debt problems in Europe.
In this article, I lay out the bullish and bearish arguments to help you make up your own mind as to which set of arguments is more persuasive.
The Bull Case
1) The Negatives are Already Priced in: What this means is that the sum total of all bad or negative news about the U.S. and global economy is already well known and reflected in current prices. It seems quite plausible since questions about the U.S. economic outlook, concerns about the Euro-zone’s future and China’s growth trajectory have been around for a while now and are no longer ‘news’ to any market participant.
2) Domestic economic picture is quite robust: Friday’s jobs report is not the only evidence in support of this argument. The country’s housing market also appears to be showing signs of life. Homebuilder optimism remains high, construction activity is improving, housing inventories are coming down and prices have stabilized. At a minimum, housing-related activities should be a net positive contributor to growth instead of a drag going forward.
3) Central Bank ‘Put’: The U.S. Federal Reserve and the ECB did not meet market expectations last week, but many are justifiably holding out hopes that they will eventually come through. I am not sure if it’s fair to expect the Fed to ‘do more’ after the Friday jobs report, but an ECB bond purchase program could materially change the Spanish yield curve.
4) The Still Favorable Earnings Picture: Contrary to pre-season doomsday scenarios, corporate earnings are not falling off the cliff as the better-than-expected second quarter earnings season confirms. Granted, revenues are on the light side, but companies are able to beat expectations. Importantly, earnings for the S&P 500 are expected to be north of 10% next year, hardly a worrisome backdrop.
The Bear Case
1) The market is already priced to perfection: Market prices reflect consensus expectations, and current consensus expectations for GDP and earnings growth are clearly on the optimistic side. All key indicators of the economy have been consistently trending down over the last few months, but the ‘consensus’ expectation is for GDP growth of 2%-plus in the third quarter and beyond. The same goes for earnings growth next year, which are expected to be in the low double digits. Both of these growth rates should be much lower than these overly optimistic expectations.
2) Even assuming that the looming Fiscal Cliff issue is adequately addressed (no minor assumption, given past history), the U.S. economy is on an unmistakable decelerating trend. The economy expanded at a 1.5% pace in the second quarter after the 2% growth rate in the first quarter. Measures of consumer and business spending are down and the manufacturing sector, which has been key growth driver thus far, has at best stalled as the two sub-50 ISM readings show. Housing is admittedly a potential positive, but the recovery is way too tentative and weak to be a growth driver at this stage. Bottom line, the best that the economy could do would be something along the lines of what it did in the second quarter (1.5% growth) and likely even lower.
3) More Fed ‘QE’ is irrelevant: Potential action from the ECB will be material to the Euro-zone outlook as it will pull back Spain (and Italy) from the brink and give the union leaders more breathing room. Germany’s dogmatic stance makes it doubtful whether the ECB will have the free hand it needs, but the idea is nevertheless a net positive. The same can’t be said of more ‘QE’ from the Fed. Irrespective of whether the QE question is still alive after the latest jobs report, it is of limited utility to the underlying economy given where interest rates are already.
4) Earnings have not been a drag, but they are hardly strong: The better-than-expected second quarter reporting season shouldn’t distract us from the fact that the earnings picture is hardly in good shape. Yes, roughly two thirds of the companies beat earnings expectations in the second quarter and total earnings growth is not that bad at a little over 5%. But strip out Finance’s flaky earnings, and total earnings growth turns negative. Importantly, more than 60% of companies missed revenue expectations and pretty much all of them were quite cautious for the coming quarters. Broad based earnings growth has been a primary driver of this market since 2009, but it will likely have to navigate without this support going forward.
Summary
Over the next 2 to 3 months, as we get more clarity on issues like the U.S. election, the European debt mess, and the Fiscal Cliff, the answer to the bull/bear debate will reveal itself. One thing seems clear to me right now, though. Volatility is abnormally low, as evidenced by the VIX index trading below 16. Whether you are a bull or a bear, it seems reasonable to expect that volatility will continue to spike in the months ahead as the issues listed in this article work their way out through stock prices.