Climbing the Wall of Worry

There is an old saying on Wall Street that bull markets climb the wall of worry.  With the markets up 50% from the March lows, there are plenty of worries to go around: uncertainty about strength of the recovery, fears of double-dip recession, and the very fact that the markets went up so much in a short period of time.  On top of that, we are about the enter the statistically worst month of the year, September.  No wonder that there is a lot of talk about upcoming correction.

From the contrarian point of view, that is exactly why it won’t happen, or if it does happen, it will be relatively mild.  This rally certainly has fundamentals supporting it, in the form of improving manufacturing reports, durable goods orders, and even housing.  After severe spending cuts, pent-up demand for various goods is apparent today, especially on the business side.  A good example of this is IT industry, even though this particular pent-up demand is amplified by the upcoming release of Windows 7 operating system from Microsoft.  This week, Dell and Intel both increased revenue outlooks for the rest of the year.

The two admittedly very important missing links in this recovery are still anemic consumer spending and high unemployment.   The question now is whether employers cut too many jobs during the crisis and thus created pent-up demand for work.  There is some evidence of that in recent reports that new and continuing unemployment claims are stating to fall.  If that is the case, expect the markets to continue its climb up the wall of worry.

Has the Market Topped?

The second quarter earnings season is almost over, and what a season it has been!  About three quarters of companies soundly beat earnings estimates, and many firms raised their guidance for the rest of the year.  That, together with a number of rather benign economic news, propelled the markets to their yearly highs, and to nearly 50% gain from the March lows.  Did this 5-month run happen too fast and is it too much?

While the rise has been extraordinarily swift and sharp by any standards, one needs to put it into perspective.  Year to date, S&P 500 is up solid, but unremarkable 10%.  It is still down nearly 20% compared to one year ago.  And it is still more than a third off its top reached in the fall of 2007.  There is a similar, and often even more exaggerated, situation with individual stocks.  A number of them tripled since March, but they are still down 20-30% compared to one year ago.  In fact, if we could erase tremendous volatility of the year past, we would be in the run-of-the-mill, ordinary bear market.

So where do we go from here?  Will the rise continue or is the bear still in charge?  No one is qualified to make a short-term prediction.  However, it does appear probable and even likely to see some consolidation in the market during the next two months, especially since little new earnings reports will be coming out until Q3 results start rolling in mid-October.  First and second quarter results were better than expected, and according to cockroach theory, this is likely to continue.  In fact, analysts are already increasing their Q3 projections from a loss of 8.5% to a loss of 2%.  I wouldn’t be surprised to see a gain.  And in Q4, earnings are expected to rise by massive 270%.  Year 2010 will also see easy earnings comparisons, which bodes well for stocks.  This should also put a lid on P/E ratios — currently they are elevated for many companies as is always the case during difficult times.

As I mentioned, the economic news have been rather positive lately.  We have seen improvements in housing market; manufacturing activity and industrial production are increasing.  The Fed finally stopped calling the economy contracting or slowing.  Most likely, the recession is already over, and we will see slight GDP growth in Q3.  Not just the US is improving: the recession is now officially over in France and Germany, and emerging markets continue their growth.  On the negative side, consumer sentiment is still rather grim and unemployment is high.  Until it improves, the growth is likely to be rather muted.

The huge market move in late 2008 – early 2009 took practically everything down, and the recent move took practically everything up.  Now, however, I think that we are returning to more or less normal market conditions, where the skill of stock picking will make a difference again.  Some stocks are fully valued, but there are still plenty of bargains and many opportunities for a long-term investor.

Old Levels Retaken

Today, the markets broke through psychologically important barriers of 1,000 for S&P 500 and 2,000 for Nasdaq, levels not seen since last fall.  Despite the gains, both indices are still about a third off their highs reached in the fall of 2007.

For complete details, look at this Wall Street Journal article.