May 21 Daily Market Assessment

No Downturn on Friday, but...

I'm still waiting for a retracement. Here's why (From Briefing.com):

Earnings growth is slowing. There are clear economic risks. Geopolitical issues are serious. Yet, none of these seem to matter to the stock market. Every time the market takes a dip on bad news, it is seen as a buying opportunity. Long-term optimism is overpowering the fundamentals. This increases risks.

A Synopsis of Our View
We have written frequently the past few months that the stock market has gotten ahead of the fundamentals. We still strongly believe that is the case. Yet, at the same time, we have retained our Market View rating at Moderately Bullish. This is because the market momentum is very strong. We haven't dropped our market rating because we recognize that the stock market doesn't move in lock-step with the fundamentals. There is no sense fighting the trend.

Furthermore, valuations are reasonable. Not great or compelling, but reasonable. There is still plenty of liquidity looking for investments. This is particularly true in terms of private equity and corporations with very strong balance sheets. This is driving the acquisitions that are helping to support stock prices. Individual investors are also continuing to invest in stocks as the alternatives in bonds and real estate are less attractive. Thus, while there is a very good argument that the stock market is becoming somewhat overvalued, there is also the simple fact that overvalued markets tend to become more overvalued. This is particularly true in periods when there is a high degree of liquidity.

Weaker Fundamentals Can Not be Ignored
It is our job to present analysis to help readers make better investment decisions. As such, it is important for us to stress that the fundamentals have worsened.

Earnings growth is clearly slowing down. The approximate 8 1/2% earnings growth for the first quarter was met with great enthusiasm in the stock market, but it was no greater than what was expected at the start of the year. It is down from the double-digit rates of 2006. Further declines to growth of 5% or less is likely in the second and third quarters. Earnings growth is being squeezed by slower revenue increases and some margin pressures.

There is additional risk to the economy near-term that threatens to further harm earnings. Consumer spending trends are fragile and rising gasoline prices, slower employment growth, and the ongoing housing slump threaten to dampen growth.

The interest rate outlook has also worsened. It is now a year since the stock market started anticipating a Fed rate cut "a quarter or two down the road." Not only has the rate cut not come, but the most recent policy statement shows no leaning towards any easing.

Not to Worry
The general reaction in the stock market is to view all these events in the most positive light possible. The first quarter earnings were met with huge cheers even though it was a typical quarter in terms of the number of companies beating estimates and the amount by which earnings beat aggregate forecasts.

The economic data haven't sparked any stock market rallies, but the disappointing trends haven't hurt much either. Real GDP growth in the first quarter of this year was at a very disappointing 1.3% annual rate and forecasts are for about 2% to 2 1/2% growth for the second and third quarters. That hasn't slowed the stock market rally at all.

Most interesting is the continuing optimism about a Fed rate cut just around the corner. On Friday, the stock market rallied after a modest 0.2% drop in April retail sales. This was widely reported to be due to the fact that the weak number increased the likelihood of a Fed rate cut.

This was absurd. The day before, the stock market tanked on weak data from retail chains on April same store sales. There was no talk that day of a Fed rate cut. One day, weak retail sales were bad for the market. The very next day, the same type of data was very good for the stock market.

Sentiment Trumps the Fundamentals
The market rebound on Friday had very little to do with the fundamentals. Instead, it was simply the underlying bullish sentiment reasserting itself after a market decline. The stock market rebounded sharply and steadily following the February 27 plunge sparked by the sell-off in the Shanghai market. It has rebounded after every smaller dip since then as well.

Traders and investors are once again being trained to view every dip as a buying opportunity. The constant headlines of the Dow or S&P hitting new highs is keeping sentiment positive. Complacency has set in about the fundamentals. They don't matter right now. The thinking is that everything will be fine in the long run. Stocks always go up.

What it All Means
We aren't complaining that the stock market isn't responding rationally to the fundamentals. This happens all the time. We also aren't saying that a bubble similar to the late 1990s is forming. At worst, this is a process of moderate overvaluation.

Yet, the S&P 500 index has run up 22% since the lows of mid-July last year. It is up 6.2% so far this year, equivalent to a 16.5% annual rate of increase. This has occurred amidst a stable interest rate environment and a worsening earnings outlook. The market is clearly outrunning the fundamentals.

Investors need to understand that they aren't getting bargains on stocks right now. They also need to understand that sentiment shifts occur. If one occurs now, the downside risk is increased by the fact that stocks have gotten ahead of the fundamentals.

For now, we are retaining our Moderately Bullish view on the stock market. We are also maintaining our extremely cautious stance with a sharp eye towards anything that could undermine the current momentum. The longer the stock market outruns the fundamentals, the more the risks increase.

Summary: Short-term Neutral, Long-term Bullish