In looking at this market, you really have to ask yourself one question: Are you an investor or are you a trader? If you are an investor, the current downdraft in the market is doing you a huge favor. If you are a trader, you might try to take advantage of the momentum to the downside.
Investor: Earnings and Interest Rates
Over the long term, stocks are going to be driven by two things: earnings and interest rates. Most investment analysis is really focused on those two things and the factors that go into them, whether on the micro scale of a research report or on the macro scale of big economic trends.
A stock’s price is what the company earns per share, and the multiple that the market is willing to pay of those earnings. Under normal circumstances, though, the biggest influence on what sort of multiple a company will get (and indeed the market as a whole) is the level of interest rates. The lower they are, the higher the multiple should be.
Trader: Greed and Fear
However if the only thing that influenced the market were earnings and interest rates, it would be very rare to see the market go up or down by even 1% in a given day, especially if there was little movement in interest rates. In the short term, the day-to-day volatility in the market is largely driven by two of the most basic of human emotions: Greed and Fear. Both can be extremely contagious.
There are also hundreds of billions of dollars traded each day partially based on what is known as technical analysis, or the use of price and volume trends to try to predict where prices will go in the future. Personally, I am not a big believer in technical analysis, but since so much money is run using it, it is foolish to ignore it entirely, particularly in the short term.
Earnings Up, Rates Down, Valuations Attractive
If you really are an investor, you should be licking your chops about a market like this one. Those long term fundamental forces of earnings and interest rates have rarely looked better. In the first quarter, the S&P 500 reported total net income that was 45% above the total net income a year ago. Excluding financials, earnings were up 40% in the first quarter, compared to growth of 13% year over year.
Analysts are tripping all over themselves to raise earnings estimates, not just for the rest of 2010 but for 2011 as well. Right now the consensus forecast is for earnings to rise by 39% for all of 2010, and for another 18% growth in 2011.
As for interest rates, they are very low and falling like a rock. The 10 year T-note is currently at 3.21%, down from 3.80% just a month ago and at its lowest levels in a year. From a longer term perspective, interest rates are far below where they have tended to trade since WWII. This makes stocks very attractive relative to bonds right now. If you are an investor, you should be buying right now.
Technical Damage
If you are a trader, things look very different. The recent plunge did some serious damage to the charts as the S&P 500 went through its 200-day moving average like a hot knife through butter. The inept response to the Greek situation by leaders in Europe has shaken confidence and brought back memories of 2008. Fear is clearly in the driver’s seat, and the downward momentum is likely to persist at least for a few more weeks.
The most immediate effect has been the plunge in the value of the euro and the rise in the dollar. This could provide a headwind to the U.S. recovery, but there are substantial offsets to that. The rise in the dollar/fall in the euro is one of the key reasons that interest rates have fallen so much. Lower interest rates are good for economic growth, particularly in a non-inflationary environment. Oil prices have also plunged, which is a big net positive for the U.S. economy.
Great Opportunities
While on balance these developments might prove to be a wash for the overall economy, there will be winners and there will be losers. In my Zacks Strategic Investor service, I have recently raised cash to sidestep the current decline. However, I plan to put that cash back to work in a relatively short period of time. The current decline is creating some great investment opportunities, and I plan to take advantage of them.
If you want to see the specific stocks that I think are best positioned, and get in depth analysis each day about both the short and long term future of the market, this is a great time to look into the Strategic Investor. To help you take advantage of this market downdraft, Zacks is making it available at its lowest-ever cost, but only until 11:59 pm Saturday, May 22.
Learn more about the Strategic Investor now >>
Sincerely,
Dirk van Dijk, CFA
With more than 25 years of experience as an analyst and portfolio manager, Dirk is Zacks’ Chief Equity Strategist. He regularly authors market strategy reports and articles, and appears on many investment TV programs. He also manages the long-term investing service, Strategic Investor.
