The Washington debt debate has stolen the spotlight from everything else. The broad market sell off this week is due mostly to the uncertain environment created by this issue. Granted, it is easy to be spooked by a debt default and its impact on the fragile economic recovery.
While the prospect of a default and/or rating downgrade has become the darkest cloud on the economic horizon, there is no shortage of other bugbears either. There are questions about the U.S. economy’s near-term growth prospects following its weak performance in the first half of the year, as the Friday GDP report showed in abundance. Europe is only just getting out of the gloomy headlines following the second Greek bailout.
The stock market reversal in the last few days is prompting some to question the staying power of the impressive gains made earlier. Till a few days ago, the broad market indices had reached close to the late-April highs.
The near-term growth outlook for the U.S. economy is the real uncertainty facing the markets, in my view. The dominant view, with which I agree, assigns the blame for the first-half economic slowdown on transitory forces, such as high gasoline prices and disruptions from Japan’s earthquake. The reversal of these temporary restraints in the coming days will lead to a strong growth revival in the back half of the year. Some evidence of that is already emerging.
Is There Room for Optimism?
I am not one to say that there are no clouds on the horizon, but I find it difficult to buy into the current level of pessimism either. So yes, there is plenty of room for optimism. Here are three examples:
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A – The Debt Debate is Much Ado About Nothing: With the Tuesday deadline around the corner and the two sides on opposite poles, the odds of a comprehensive budget deal are very low. The most likely outcome at this stage is an 11th hour kick-the-can-down-the-road solution that provides for a temporary debt-ceiling increase, while leaving the thornier deficit reduction issue for a later date.
The rating agencies have painted themselves in a corner by threatening a rating downgrade if the debt ceiling increase was not accompanied by a credible enough deficit-reduction plan. They seem to be using this event as an opportunity to buttress their image following their negligent behavior in the sub-prime mortgage crisis. But the credit markets appear to have called their bluff. With the 10-year Treasury bond in the 3% vicinity, there are no signs of panic in the bond market. As such, the loss of the ‘AAA’ rating may not exactly be an end-of-the-world event after all.
B – Solid Corporate Earnings: While the economic recovery has been relatively erratic, the earnings recovery has been quite stellar thus far. And it is corporate earnings that have the highest correlation with stock prices in the long run.
It is perfectly fair to question the sustainability of corporate earnings growth given the recent run of soft economic reports. But the reality on the ground is quite reassuring on that front. The U.S. economy started losing steam in the first quarter as the GDP report showed, but we saw little evidence of that on the earnings side. And the earnings performance in the second quarter thus far has been even better than the first quarter. With U.S. economic growth expected to resume in the coming days, the earnings outlook should remain fairly robust going forward.
C – Interest Rates Remain Very Supportive: It is hard to categorize the interest rate environment as anything but supportive given the historically low levels of short- and long-term rates. The interest rate backdrop has remained favorable even in the face of a number of dark clouds. In addition to the end of the Fed’s QE2 program, the market has had to contend with the debt-ceiling debate in the U.S. and the sovereign debt issue in Europe.
Even if we explain the current under-3% 10-year Treasury yield on the flight-to-safety trade in response to soft economic data, we see little sign of stress in the corporate credit markets. Bottom line, interest rates matter to investors and the current low interest rate environment is a major key positive for the stock market.
Making It All Work For You
The herd mentality of investors is well documented. Everyone piles into the momentum trade when all is hunky-dory, but run for the hills at the first sign of trouble. While that is a bad investment style at any time (if that can be called a style at all), it is particularly unsuited for these turbulent times.
You don’t need to be a professional to make money in this market. But make sure you understand that consistently picking winning stocks requires a disciplined due diligence process. While such winners have many attributes, three really stand out: Earnings Growth, Quality and Valuation.
• Earnings Growth: The most important attribute of a winning stock is its earnings growth profile. But more than just plain vanilla earnings growth, what makes the stock soar is the company’s ability to produce positive earnings surprises. The Zacks Rank helps you capture this key growth attribute. At any given time, stocks with a Zacks #1 Rank offer the best earnings growth profiles of the entire market.
• Quality: Quality has its subjective components, but I am referring to the quality of the company’s: product/service, financial health and management. You want to invest in a company that enjoys a competitive advantage in its product/service market, is in strong financial health and is led by a proven management team. There is nothing subjective about any of these attributes.
• Valuation: If all the positives about a company are already out there in the market, then you may have already missed the bus. How can you tell if that is the case? Looking at the company’s valuation multiples, such as price-to-earnings (P/E) or price-to-book (P/B), and comparing those to its peers should give you a good idea of relative valuation. Buying a quality stock at a discount to its peers is your best bet for generating an above-average return.
The best way to analyze, choose and track such winning stocks in any market is by using the tools and resources available in Zacks Premium. You can try Zacks Premium, and receive unlimited access to our exclusive Zacks Rank, for 30 days free.
Sheraz Mian
Sheraz Mian is the Director of Research at Zacks Investment Research where he relies on access to valuable data to assess winning stocks and funds. Now, you can access the same data free for 30 days just by trying Zacks Premium.
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