Market Correction Comes and Goes Much Like Last Year

Did you notice the S&P 500 hit a new high today? It seems this market corrects much more fast and furious than in prior periods, but the corresponding snap back is just as quick. If you blink, you might miss it. Just last month we were spooked by a 400-point one-day drop in the Dow after a huge sell-off in the China market. Chinese stocks rebounded to make new highs and now the U.S. market has done the same. The 2006 correction was very similar, short and swift. In fact, compare the two charts:

Bears will undoubtedly be looking for a failed breakout and another leg down. Despite the fact that the market has been pricing in an interest rate cut, and yet no rate cut seems imminent, stock prices keep chugging along. I am in the camp that believes the Fed is on hold and won’t cut rates due to a perceived credit crunch. Things would have to get meaningfully worse on that front for Bernanke to move, in my opinion.

Where does that leave stocks? I am still standing by my mid-to-high single digit return prediction for the U.S. market in 2007. Currently the S&P 500 is up 3.5% year-to-date. I just can’t get overly bullish with decelerating profits and a Fed that is still concerned with inflation. What would be the catalyst for a big move up? Earnings would have to really be strong. I’m not expecting a huge downward revision to current estimates, but this economy doesn’t seem to me to have much upside right now.

With what we know now, the market seems pretty fairly valued overall. I think we’ll trade between 14 and 16 times earnings in this environment. The strategists calling for P/E expansion I think are dreaming. Sure employment is high and interest rates and inflation are relatively low, but we still have single digit earnings growth and a slightly above-average valuation on the market. Hardly reason to be overly bullish.

In times like these, I’d suggest investing in cheap companies rather than a fairly valued market.

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2 Thoughts on “Market Correction Comes and Goes Much Like Last Year

  1. Why do you think profits are decelerating? I’m hearing this often and I guess there is some of it to be seen in the current earnings reports, but I can’t figure out exactly why this has suddenly become sort of a hot button topic for people providing economic analysis. It seems that consumer spending has remained strong and low unemployment should bouy spending yet it seems that most company’s are cautioning against being too optimistic on earnings over the rest of the year. I know Southwest did so recently despite the fact that almost every airline is reporting strong demand and that really confused me.

  2. Chad Brand on April 20, 2007 at 8:53 AM said:

    Hi Dan,

    There are a few reasons why earnings growth has slowed to the single digits. It mostly has to do with a couple sectors that make up a large chunk of the S&P 500; financials and energy.

    Together they represent about one-third of the S&P 500’s market cap. Energy companies have very high prior year comparisons for earnings due to huge price spikes (gas over $3, oil prices over $70, etc). An even bigger contributor is financials as banks are seeing their margins squeezed by the flat yield curve and now the mortgage mess isn’t helping either.

    Consumer stocks have seen earnings do well, as you point out, but a few sectors are weighing down the mean growth rate in earnings.

    Part of overall company cautiousness is just management wanting to set the bar low so they can meet or exceed it. Guidance has been less aggressive in recent years for that very reason, which is why you see the majority of companies meet or beat consensus estimates.

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