To say that these are turbulent times would be an understatement. The market gyrations of recent days reflect deep uncertainties about its direction.
This has shown up in volatility measures like the VIX Index. As you will see in the VIX Index chart below, market volatility roughly doubled last week to its highest level in over a year. In fact, the VIX reached its highest level since the last quarter of 2008.
The Index has since come down, but still remains elevated by historical standards and appears to have an upward bias.
This begets the questions: Is this high level of volatility here to stay? And how should investors account for it in their investment decisions?
Volatility Comes Down
I don’t buy into the continued-turbulence thesis, which calls for sustained levels of high volatility. My prediction is that calm and stability will return to the markets in the coming days. This is not just wishful thinking on my part. It reflects a level-headed appreciation of the market’s strengths and vulnerabilities.
The larger-than-expected European bailout package should put aside fears of contagion that were threatening to derail the U.S. economic turnaround. The current Euro weakness is not due to continued funding/liquidity concerns. It is reflective of a weak growth outlook for Europe given their need for stringent austerity measures to tackle fiscal imbalances. And I would ascribe the continued high VIX levels to the market’s relatively-fresh wounds from last week’s turmoil. Give it a few more days and it should come down some more.
While some headwinds remain, such as concern about China’s economy, my overall outlook is for the markets to maintain a positive bias in the coming weeks.
The key drivers of this stabilizing trend stem from developments in three areas: the Economy, Earnings and the Fed.
1) Economic Recovery Gets Entrenched
Confidence in the sustainability of the economic recovery should improve in the coming months. This will be propelled by positive developments in the labor market. It has become obvious now that the U.S. economy can move along on its own once the training wheels start to come off later this year.
As we saw in the April payroll numbers and subsequent claims data, the labor market has turned around. Not only did we get a very strong private sector job creation performance for the month, but the March and February numbers were also revised upwards. With the continued strength in temp jobs and the uptick in the length of the work week, the outlook for the coming months remains positive.
While I have no illusions about the extent of the labor market problems facing us, I am reasonably confident that consumer confidence and the economic recovery will move on to even surer footing in the coming days.
2) Solid Earnings Outlook
Corporate earnings represent the lifeblood of the stock market. And almost side by side with the economic recovery has been an impressive turnaround in earnings. With the first quarter earnings season winding down, we witnessed an impressive 41% jump in profits (excluding financials) with an above average number of firms coming in ahead of expectations. Current expectations call for earnings growth of 39.2% this year and a further 17.8% in 2011.
No doubt the dollar strength and the expected European slowdown may have some dampening effect on earnings, which could start showing up in future estimates. But the overall improving trend in earnings is unmistakable.
With 2011 earnings expected to be in the vicinity of its prior 2007 peak, the market should be headed back to those higher market levels as well.
3) The Fed Remains on Hold
While we have all along expected the Federal Reserve to remain on hold through most of 2010 in terms of interest rates, we are even more confident in that assessment following the recent developments in Europe. Focusing on jobs and inflation are the core mandates of the Fed. And trends on both fronts should make it easy for the central bank to stay accommodative with low rates.
But important as it is, the equity markets should not be as fixated on the Fed move as appears to be the case at present. Interest rates are at such low levels that even after multiple small-increment increases, overall rate levels will still be in the accommodative territory. But more important than that, the start of a tightening cycle by the Fed will be clear evidence that they expect the economy’s growth trajectory to be strong and self sustaining. And there’s no better elixir for the equity markets than a growing economy.
Investment Implications
Instead of running for cover as many do during turbulent and high-volatility times, my outlook of stability-returning-to-market calls for staying invested in the stock market.
Certainly you can just do index funds and get average returns. However, if you are interested in topping the market, then you need to concentrate on these key attributes of winning stocks:
- Earnings Profile: The most important attribute of a winning stock is its earnings profile. A company’s ability to consistently grow its bottom line is a quality that gets rewarded in a rising stock price. But just plain vanilla earnings growth is not enough to push the stock price higher. Current consensus earnings expectations already capture the company’s growth prospects. It is growth prospects beyond current expectations that are relevant to the stock price. The Zacks Rank helps you capture this key earnings growth attribute.
- Valuation: If the stock price has already moved to reflect its impressive earnings profile, then you may have already missed the bus. So look for stocks that are trading at a discount to peers. While you can select from a large menu of valuation metrics, some of which are quite sophisticated, I have personally found the good old forward P/E to be a fairly reliable metric in most cases.
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Best,
Sheraz Mian
Sheraz 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 gain access to the same research he uses every day for free. Just try Zacks Premium for 30 days at no cost and no obligation.
