Broker Check

New Fears Attacking Market – Should We Be Scared?

| May 17, 2021
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When it comes to stocks, everyone who follows the market knows it has rotated bigly (sorry, couldn’t resist!) over recent couple of months, and the past week was no exception.

Stocks were wild and weird, especially since it’s the best earnings season of our lifetimes. Stocks should be zooming, and everyone should be happy, right? But the NASDAQ was punished, and the Russell 2000 is also extremely choppy. That’s why we're seeing wicked rotations under the surface.

Now, understand that rotations like this have gone on forever – it's not the first or last. But before we get into reasons why prior high-flyers are getting smoked while previous deadbeats are the new high-flyers, we'd like to note we’re not that worried in the intermediate or long term. While we expect the market to be choppy with some continued selling pressure in the short term, that will lead to opportunity.  Why?

  1. Volume has been overall low, with thus far only a few days of high, volatile volume (see mid last week
  2. Current charts look similar to late February, right before stocks took off (see the trusty MAPSignals Big Money Index (BMI) below), remembering that the BMI is typically a leading indicator
  3. We're already seeing the market settle under the surface on some days (like Thursday and Friday last week), likely due to underlying buying support as stocks “on sale” present themselves

Now back to the issue at hand, what are the new fears tripping up traders and algorithms? We’ve identified four.

High Valuations

Current calculations have the S&P 500 at a price-to-earnings (PE) ratio of around 45. That's three times the 150-year mean of 15 and has many investors and algorithms freaked out. We believe this is a false narrative though, as that 45 is a trailing PE. FactSet calculates the forward 12-month S&P 500 PE at 21.6. So, while prices are rising, earnings are rising faster. Therefore, PE ratios will fall, not because prices will fall to meet earnings, but because earnings will rise.

Peak Earnings Momentum

With 88% of the S&P 500’s companies reporting earnings, 86% of them have beat earnings estimates and 76% beat revenue estimates. That’s an earnings growth rate of 49.4%, which means companies continue to outperform but are still being sold. The fear is that this is as good as it will get, and thus earnings have hit a peak. While we believe this can be a legitimate worry, the data indicate earnings will continue to grow at breakneck speeds for the rest of the year (see High Valuations above). Therefore, we're still bullish long-term.

Taxes and Inflation

We've talked quite a bit about both of these topics. But really, what is most important is the potential fear of long-term capital gains being hit hard by the Biden administration. However, remember in the Fidelity study we mentioned last week, since 1950 the S&P 500 rose 12 out of the 13 times tax rates have been increased. And politicians know (via their silence on this issue) that attacking dividend income would surely cost them votes. This corresponds with our thesis that equities, and especially dividend growth equities, are a great hedge against potential rising taxes and inflation.

Seasonal Volatility

While there have been volatile days recently that may seem to endorse a selling strategy (seasonal volatility is real), remember that over time earnings should be bringing up volatility instead of the sloppy volatility and cyclical churn we're seeing right now. What we mean by that is we are seeing value and “reopen stocks” (materials, energy, industrials, financials, communications, and discretionary) being bought at almost historic levels. The companies doing the best have sagging stock prices, while those expected to do better are awash in praise:

This rotation can also be seen in exchange traded funds (ETFs). Big ETF trading is even clunkier than stocks right now, showing sells of “stay at home” (i.e., growth) equities and buys of the “reopen” value stocks:

In the chart above, that recent run up in buying is actually just a rotation, with a sharp drop off mid last week into selling, albeit mostly in the previously loved growth sectors. We saw 141 ETF buy signals in the previous week and only 12 sell signals, prior to mid last weeks volatile growth selling. That may seem lopsided and contrary to what we're seeing in the overall market but it’s indicative to the “sloppy churn” going on right now. But what's interesting is the furthering of this rotation. We're seeing buying in commodities, value, dividends, industrials, miners, and home builders. And then we're seeing selling in growth, solar, clean energy, biotechnology, and short-term bonds.

This is illustrated well in some popular Ark Invest ETFs from investment manager Cathy Wood. There have been huge sells in the ARK Genomic Revolution (ARKG) and ARK Innovation (ARKK) ETFs. The selling was so great there were rumors of redemptions. This accelerated the fear-driven “big money” sells (often likely algorithm-based), which then subsequently put pressure on U.S. stocks.

It’s important to keep in mind that the drivers of what’s happening are known. So, don’t let fear, uncertainty, and doubt lead to bad decisions. Remember, the economy is reopening in full force, vaccinations are progressing quickly, there's monster pent-up demand, and hopefully taxes will not sink stocks. To sum it up, it only takes a little fear to get a big rotation underway.  So be prepared for this cycle of up and down days in the short term.  But remember that the bottom line is that even if stocks continue to head a little lower in the short term, this is not a time to freak out and become a sad bear.  This is natural and helps refresh the market while actually providing opportunity for the long term investor.

*Cornerstone Financial Services, LLC and Daniel Milan do not currently own any ARK funds in investment models or personally.

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial Services, CoreCap Investments, and CoreCap Advisors are separate and unaffiliated entities.

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