— Elvis Picardo is a strategist and analyst with Global Securities in Vancouver, Canada. The opinions expressed are his own. —
By Elvis Picardo
VANCOUVER, Canada (Reuters.com) - Three months ago in this column, on the heels of the S&P 500’s best 14-trading day performance since 1938, I had posed the question - have the markets turned the corner? With the index now up 38 percent from its 12-year low posted in March — taking it into positive territory for the year — the answer is an unequivocal “Yes.”
But just as it is dangerous to drive around a corner at high speed, the velocity and momentum with which the S&P 500 has turned the corner, so to speak, has caused some concern about its future direction. Will it skid off into the red once again, or will it stay in the black?
In order to assess where we go from here, let’s look at the prognostications that emanated this week from heavyweights such as the World Bank, Organization for Economic Cooperation and Development (OECD), and Federal Reserve. Their forecasts paint a somewhat mixed picture in terms of the outlook for the U.S. and global economy.
The World Bank had the most downbeat assessment of the three. In a report released on June 22, the World Bank noted that prospects for the recovery of the global economy are unusually uncertain, and the sharp decline in global GDP, industrial production and trade in the fourth quarter of 2008 and the first quarter of 2009 are without modern precedent. It said that although there are signs of stabilizing economic activity in the U.S., and of recovery in China, there are also “ample indicators” of a deepening and spreading recession. The World Bank forecast global GDP will contract by a record 2.9 percent this year, compared with its previous forecast for a 1.7 percent contraction. It expects the U.S. economy to contract by 3 percent this year, compared with its previous forecast for a 2.4 percent decline.
Coming as it did at a time of growing uneasiness about the sustainability of the recent rally, the gloomy prognosis led to the biggest one-day decline in two months for U.S. and European stocks. Fortunately, the damage was limited by remarks from the OECD and Fed on June 24, which while not really upbeat, did seem to indicate that the worst may be over.
The OECD revised growth projections upward for its 30 member nations for the first time in two years. That’s not to say that the group expects a miraculous turnaround in economic activity. Its secretary general said that while OECD activity now appears to be reaching bottom, the ensuing recovery is likely to be weak and fragile for some time. The OECD now forecasts economic activity for the group as a whole will shrink 4.1 percent this year and grow 0.7 percent in 2010, compared with its March forecast for contractions of 4.3 percent and 0.1 percent respectively. It noted that signs have multiplied that the U.S. economy could bottom out in the second half of this year. As a result, the OECD now expects the U.S. economy to contract 2.8 percent this year and expand by 0.9 percent next year, compared with its previous forecast for a contraction of 4 percent in 2009 and flat growth in 2010.
As for the Fed, it said that information received since its previous meeting in April suggests that the pace of economic contraction in the U.S. is slowing. The Fed also said that economic activity is likely to remain weak for a time, but it anticipates that the combination of policy actions, fiscal/monetary stimulus, and market forces will contribute to a gradual resumption of growth. In other words, although Fed Chairman Ben Bernanke may be seeing “green shoots” in the U.S. economy, it may take quite some time for them to sprout into saplings.
In my opinion, this caution is justified, as positive indicators continue to be offset by continuing decline in house prices and rising unemployment. On the plus side, the index of U.S. leading economic indicators rose for the second successive month in May, posting its best back-to-back performance since 2001. Durable goods unexpectedly rose that month, and consumer confidence rose in June for the fourth straight month. On the minus side, existing home prices tumbled 17 percent in May from a year earlier, the third-biggest decline on record. One-quarter of U.S. states now have jobless rates above 10 percent, and unemployment in eight states including California and Florida has reached the highest level since at least 1976.
But that degree of caution is not evident in analysts’ earnings estimates, which I believe are factoring in a recovery next year that may be stronger than what the Fed and others currently expect. According to “bottom-up” earnings estimates compiled by Standard & Poor’s, EPS for the S&P 500 index is currently forecast at $55.81, which would represent a modest recovery of 13 percent after a 40 percent plunge in 2008. However, EPS next year is forecast to grow 33 percent to $74.32, led by a strong rebound in earnings for the Materials, Energy and Financial sectors.
Indicators such as insider sales and short sales are also flashing amber, signaling that the rally may be in danger of stalling. TrimTabs Investment Research said last week that the supply of stock for sale is far outpacing demand. TrimTabs notes that since the beginning of May, secondary stock offerings of $98.5 billion exceed cash takeovers and buybacks by a factor of 4.6, while insider selling totaling $3.9 billion exceeds insider buying of $350 million by a huge margin. According to InsiderScore.com, insiders of S&P 500 companies have been net sellers for 14 straight weeks, and have been selling stock at the fastest pace in two years. In addition, short interest on the S&P 500 climbed to 9.8 billion shares as of June 15, up about 1 percent from two weeks earlier. Although the increase is marginal, the fact that this was the first increase in short interest since March may be of some significance.
My view is that the easy money has been made on this rally, and incremental gains will be harder to come by. With market volatility as measured by the VIX having plunged 70 percent from its record level in October, I believe that the next phase of the rally is likely to be accompanied by a moderate rebound in volatility. Against this backdrop, investors may wish to consider reallocating part of their portfolios to defensive sectors such as Healthcare and Utilities, which have been shunned as investor interest and capital has gravitated to the Financial and Energy sectors.
Overall, there seems to be growing reluctance among market participants to push U.S. equities higher in the short term, judging from the fact that the S&P 500 and Dow Jones Industrial Average are both little changed so far this month. Having turned the corner at impressive speed, this tapping on the brakes may be just what U.S. equity indexes now need if they are to move higher in the months ahead.