Back to top

Market Analysis

Stocks have made steady gains in recent days, erasing the early-summer losses and getting back to the Spring peak. Last Friday's better-than-expected jobs report is the most recent of positive catalysts for the stock market momentum. But stocks were holding out quite well even before the labor market reading, with many investors hoping for another round of market-friendly activity from the Fed. Strong rhetoric from Mario Draghi, head of the European Central Bank, has also been stoking expectations that the ECB may be onto something.

This turn of events runs counter to what I have been arguing for in this space since Spring and naturally begs the question of where we go from here. I still lean bearish in my near-term outlook as I continue to see the horizon as being fairly cloudy. But in this piece, I survey the landscape of bullish and bearish arguments to help you make up your own mind as to what set of arguments carries more weight.

Let's talk about the Bull case first. Also check out my Colleague, Kevin Cook's excellent article on the topic here: Have We Seen the Lows for the Year?

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.

Let's see what the Bears have to say in response.

1) 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. 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 was a key prop for this market since mid 2009, but it will likely have to navigate without this support going forward.

Putting It All Together

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. And I expect this trend to continue for some time, at least through the remainder of this year.

The picture is expected to be a lot clearer beyond the next 6 to 9 months, as we get more clarity on the issues facing the market at present. As such, while I am bearish near-term, my long-term view of the market is quite favorable. I continue to argue for being fully invested and caution against the risks of market timing. That said, it makes perfect sense to position your portfolio for a period of above-average downside risk.

Focus List Update

We made two changes to the Focus List this week – adding and deleting one stock each. Exiting the portfolio is Watsco (WSO - Analyst Report) and it gets replaced by Agrium (AGU - Analyst Report).

Watsco, the heating, ventilation and air conditioning vendor, is leaving the Focus List because it fell to a Zacks #5 Rank (Strong Sell) following its earnings miss, which raised questions about the company's ability to benefit from the budding housing recovery.

We replace Watsco with Agrium, a major North American fertilizer maker and distributor, to reflect the company's exposure to the improved grain price backdrop following the drought. Crop nutrient demand historically increases following droughts and this puts Agrium in an attractive position. Earnings estimates for this Zacks #1 Rank (Strong Buy) stock have been steadily going up in recent days, reflecting its recent strong quarterly results and this favorable macro backdrop.

As you all know, the Zacks Rank is our primary stock selection tool for the Focus List. We typically pick only Zacks #1 Rank or Zacks #2 Rank (Buy) stocks and get rid of stocks that fall to a Zacks #4 Rank (Sell) or Zacks #5 Rank. We strictly follow the discipline of this framework, keeping deviations to the minimum. But the need for manual over-rides can't be entirely eliminated. I have retained MarkWest Energy Partners (MWE - Analyst Report) in the Focus List despite it occasionally falling to Zacks #4 Rank and will need to do the same for P.S. Business Parks (PSB - Analyst Report), a REIT that manages multi-tenant office and business parks. Traditional measures of earnings are not that material for these yield-centric stocks, justifying the Zacks Rank overrides.

Please login to Zacks.com or register to post a comment.

New to Zacks?

Start Here

Zacks Investment Research

Close

Are you a new Zacks Member or a visitor to Zacks.com?

Top Zacks Features

My Portfolio Tracker

Is it Time to Sell?

One of the most important steps you can take today is to set up your portfolio tracker on Zacks.com. Once you do, you'll be notified of major events affecting your stocks and/or funds with daily email alerts.

More Zacks Resources

Zacks Rank Home - Evaluate your stocks and use the Zacks Rank to eliminate the losers and keep the winners.

Mutual Fund Rank Home - Evaluate your funds with the Mutual Fund Rank for both your personal and retirement funds.

Stock/Mutual Fund Screening - Find better stocks and mutual funds. The ones most likely to beat the market and provide a positive return.

My Portfolio - Track your Portfolio and find out where your stocks/mutual funds stack up with the Zacks Rank.

Zacks #1 Rank Top Movers for Zacks #1 Rank Top Movers

Company Symbol Price %Chg
RPC INC RES 24.91 +8.35%
LITHIA MOTO… LAD 94.59 +4.60%
DELTA AIR L… DAL 39.15 +3.90%
FLAMEL TECH… FLML 14.51 +3.50%
SOUTHWEST A… LUV 28.87 +2.92%