The market’s weak performance year to date shows its loss of momentum from last year’s impressive run. Lingering doubts about the sustainability of the U.S. economic recovery, due to global headwinds and domestic weak spots, have been weighing on investors’ behavior. This has resulted in extreme volatility and an overall down drift in stock prices.
Is it possible to make sense of this all around turbulence? And can one profitably navigate this choppy market?
My one-word answer to both those questions is: Yes.
My goal here is to help you make sense of it all and give you a few investment tools along the way to deal with this market environment.
A Debate is Raging
Investors are trying to size up two competing outlooks for the U.S. economy: one calls for a slowdown in growth, while the other is for a relapse into another recession. The latter outlook is also sometimes referred to as the ‘double-dip recession’ outlook.
I am looking for the economy to continue on its expansionary trajectory, albeit at a moderate pace. This view is amply borne by an objective reading of the economic scene; be it concerns about Europe, China’s growth prospects or recent developments in the U.S. economy.
My sense is that we are close to the stage where this view will take hold, helping the markets to drift higher. The second-quarter earnings season, just days away now, should help us get there, particularly if management teams can provide adequate guidance. Current expectations of corporate profitability, if confirmed by management teams on the second-quarter earnings calls, would help the market find its footing.
Let’s Size Up the Headwinds!
Here is a quick review of the major issues that the market has been grappling with recently:
- Dark European Clouds: Fears of European sovereign debt defaults, which originated in Greece but also plague Spain, Portugal, and Ireland, have not gone away, despite the joint EU/IMF ‘bailout’ package. This issue affects the U.S. economic outlook in two distinct but related ways.
- This issue keeps alive the fear of a global liquidity crunch through default(s) by one or more of the at-risk countries. This would drag down the European banking industry with it. And given the integrated nature of global finance, this could quickly morph into a global liquidity crunch. I don’t put much stock in this doomsday scenario. The odds of a default by one of these countries are very low. And the onset of the ‘stress tests’ should also improve confidence in European banks.
- European response to the crisis has involved deep spending cuts to bring deficits under control. While the long-term utility of fiscal restraint can’t be denied, this move carries the risk of pushing Europe into a deep recession. A European recession is unlikely to force the U.S. into a downturn, but will no doubt cause a moderation in growth.
- China’s Growth Prospects: China has been trying to address its property bubble and incipient inflationary pressures by slowing down its economy. As a result, we may have already seen the peak in Chinese growth in the first-quarter GDP growth rate of close to 12%. Current growth expectations are in the 10% vicinity for this year and next. I see downside risks to these estimates, but I am hard pressed to call an 8 – 9% growth rate as the end of the Chinese growth story.
- Labor Market Concerns: The economy’s job-creating performance thus far has been sub-par. While the labor market’s tepid performance is undeniable, if we look across the whole of 2010, we find a slow and steady positive trend in private sector job creations.
- Soft Economic Readings: Recent economic reports show a softening of the growth momentum in the U.S. economy, but interpreting those to mean the onset of a double-dip recession would be a stretch. Most indicators are still showing levels that indicate economic expansion.
While these issues are real, I do not foresee any of them, individually or in combination, derailing the current ongoing recovery. Some moderation in growth can reasonably be expected, but a slowdown from a 3 – 3.5% growth momentum to something like 2.5 – 3% can hardly be called a downturn. We should also not lose sight of corporate fundamentals, with cash-rich solid balance sheets and strong earnings profiles prompting increased outlays for capital expenditures and hirings. While there may be some downside risks to current earnings growth expectations, even significantly lower growth numbers than these would be inconsistent with the onset of another recession.
Making Money in This Market
It was easy to make money in last year’s bull market – everything went up, including the lowest quality and riskiest stocks. But today’s market has hardly anything in common with last year’s scene.
You don’t need to be a professional to make money in this market. But make sure you understand that what worked last year is pretty much of little value at present. You can still find winners out there, but you need to do a bit more due diligence to identify them. 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 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 more about the potential for the stock to have earnings surprises so it can grow at levels above current expectations. That’s what really makes stocks soar. The Zacks Rank helps you capture this key growth potential 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.
Where to Start
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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.
