How Markets Bottom

After the S&P 500 bottomed on March 6, 2009, the market rallied 220% during the next 6 years, reaching a high of 2134 on May 20, 2015. Over the following nine months, stock prices fell about 12%. Currently, market pundits and investors are worried that the decline has farther to go.

In recent newsletters I have written about three major concerns: a slowing global economy, political uncertainty in the U.S., and increasing geopolitical risk around the world. None of these critical issues are going away any time soon, but the potential for a powerful market rally still exists. Let me try to explain.

Markets tend to top out when the major driving forces are positive and investors begin to expect that these trends will remain positive well into the future. Conversely, markets tend to bottom in exactly the opposite fashion. In other words, when the outlook is predominately negative, eventually investors begin to feel too pessimistic about the future. The one constant in the investment markets is change. No matter how good or bad current trends seem to be, they will eventually reverse.

The art in all this is trying to predict the timing of these eventual reversals, which brings me to the title of this edition – How Markets Bottom.

Markets bottom naturally by time. After some period of time, current worries become discounted in stock prices. In essence, the level of emotional angst gradually subsides as investors get used to the issues even if they haven’t been totally solved. The fact, or even the perception, that the issues aren’t getting worse, becomes a positive.

Markets bottom by price. The overall market is bound by historical valuation ranges, incorporating several fundamental factors, including: earnings growth, interest rates, and the expected inflation rate. Over the past ten years, the market Price/Earnings ratio (PE) has traded between 12x – 22x. Currently the market PE is approximately 15.7x based on 2016 earnings estimates, toward the low end of this historical range. We expect interest rates and inflation to remain low this year, which supports higher valuations. Therefore, the key catalyst for a “valuation rally” in the stock market is earnings growth. Unfortunately, we continue to feel that earnings estimates are too aggressive, but over time they may become less so, as companies temper forecasts for the remainder of the year. We are watching very closely to see how this process unfolds. In the meantime, any further decline in stock prices will push the PE ratio closer to the bottom of the range.

Markets bottom by events. The stock market is a discounting mechanism, incorporating all known information as well as forecasts for the future. But when events unfold, that weren’t discounted or expected, markets move accordingly, often powerfully. Now, again, there is a degree of counter intuitiveness to this. Over the history of the stock market, horrific events have consistently been associated with meaningful stock market bottoms. Why? Because investors react emotionally in these situations and over-discount the negatives. When bad things happen, people naturally assume worse things will follow.

A blow-up in the Mid-East, or a horrific event within our borders, would likely rock the market in the moment. However, over the long term, any sharp decline would be a long-term buying opportunity.

The stock market has gotten off to a very rough start in the first month and a half of 2016. We may not be out of the woods yet, given the concerns previously mentioned, but the market will bottom at some point. The subsequent rally could be powerful, especially if its arrival surprises the majority of market pundits. That scenario, as history has demonstrated multiple times, is a reasonable bet.

Whiteout

Some time ago, during a typical winter day in upstate New York, my dad and I were traveling west on the thruway when we were engulfed in a whiteout near Syracuse. It was snowing and blowing so hard our visibility was zero, even the hood of the car was obscured by the blinding snow. We had no choice but to continue on, hoping to eventually drive out of the blizzard. So on we drove, with me at the wheel, looking out the driver’s side window for the guard rails on the left and my dad doing the same on the passenger’s side. It was useless to look straight ahead. We eventually made it, but it was not something I would ever like to repeat.

Predicting the market thus far in 2016 seems a bit like a winter whiteout experience. The fate of the market this year largely rests on three macro forces, each difficult to predict. First, the U.S. economy, which has been weakened by the strength of the dollar and also by the slowdown in China, is inching closer to a potential recession. The Fed, which not long ago talked about raising rates steadily during the year, may now be on hold for a while longer. Corporate profits have been reasonable, but most companies have tempered forecasts for the remainder of the year, and virtually no companies are showing greater than expected revenue growth. Whether the overall economy avoids a recession is a tough call at the moment.

Second, with so much at stake politically, the fate of the presidential election remains difficult to predict. Various industries, as well as the general business climate, will be greatly impacted by election results. With visibility limited, corporations are cautious, exacerbating the slow-growth environment. This uncertainty is likely to hang over the markets until Election Day.

Third, the precipitous decline in oil prices, and the U.S. withdrawal from world political leadership, has resulted in increased geopolitical risk in various areas of the world. This increased potential for a disruptive exogenous shock has corporations and investors understandably cautious.

In certain market environments the prudent strategy is to focus on company and industry fundamentals, and worry less about macro issues that are impossible to predict. This doesn’t mean these major issues should be ignored, but too much time spent trying to predict events that are largely unpredictable, can paralyze investment decision making. This may be one of those times.

Given this uncertainty, we feel it will be increasingly important to focus on industry-leading companies which are strengthening their competitive advantages over their peer group. In this regard, we will play less attention to short-term fluctuations, but instead concentrate on sustainable trends, including relative earnings growth, new product innovation, and operational efficiency. In most cases stock performance will reflect management’s commitment to enhancing shareholder value despite the challenging economy.

On the positive side, 2016 could be a potential record year for mergers & acquisition activity. With still solid corporate cash flow and the anti-competitive U.S. corporate tax rates, we expect M&A activity to continue to gain momentum. Generally speaking this should have a positive effect on stock prices.

There is no denying that 2016 could be an extraordinary year that charts the course for our country and markets for many years to come. Prudent investment strategy will require adaptability as well as discipline. A diversified portfolio balancing growth, income, and risk management should weather whatever storm arrives, however long it lasts.