SERIOUS MONEY:INVESTORS IN the SP500 endured the worst May since 1962 last month and, just like the "Kennedy slide" almost five decades ago, the weakness continued into early June.
Then as now, a young Democratic president from an ethnic minority had been elected on a populist agenda 18 months previously, but was struggling to make an impact. Just like today, the public was concerned that the United States was falling behind a rapidly growing adversary – then, the Soviet Union, today China.
Geopolitical risks were also rising, and fears that nuclear weapons might fall into the wrong hands were growing. Back then that concern centred on Cuba, and now it is Iran.
In a further parallel, the stock market enjoyed a powerful recovery in 1961, the previous year, as the economy emerged from recession. Bullish sentiment and valuation multiples had reached dangerous levels by winter’s end, setting the market up for a painful setback. The Kennedy stock market correction even endured its own version of the recent “flash crash” as the major market indices dropped almost 6 per cent on May 29th, 1962, and the heavy volume was such that the stock exchange could not report the day’s final trade until two hours and 29 minutes after the market closed.
Just like today, stock market weakness precipitated fears that the US economy might succumb to a double-dip. Business Week reported: “Wall Street . . . thinks that the dramatic recovery in business is over; in fact, some analysts look for a recession later this year, or maybe next year.”
Investors began to appreciate that Kennedy, who was elected on the promise that he would “get this country moving again”, was in fact a fiscal conservative, just like Eisenhower. His confrontation with the steel industry over a price increase confirmed suspicions that he would take whatever measures were necessary to throttle inflation.
A repeat of the Eisenhower administration’s record of three recessions in eight years seemed in store. The double-dip never materialised, though, and the stock market took off later in the year, once the Cuban missile crisis was resolved. Unlike today, however, stock market weakness was not accompanied by any detectable stress in the credit markets and, consequently, the setback proved to be just a healthy downward adjustment in overpriced stocks.
Fast forward to today and the drop in stock prices has been accompanied by widening credit spreads, a sizeable rally in US treasuries, while the message emanating from the financial markets is corroborated both by leading indicator indices and analysts’ earnings revision activity.
The Economic Cycle Research Institute’s (ECRI) weekly leading index growth rate peaked last October at almost 29 per cent, and has since dropped into negative territory – the first time the index has penetrated zero from above since August 2007. The current reading is consistent with real economic growth of just 1 per cent in the second half of the year – too close to double-dip territory for comfort.
The signal could be ignored but for the fact that the six-month rate of change in the Conference Board’s leading indicator and in the six-month rate of change in the Organisation for Economic Co-operation and Development’s (OECD’s) composite leading indicator paint a similar picture. The message is simple: economic growth is likely to bounce around zero in the near future.
Analysts’ optimism has soured significantly in recent weeks, as the ratio of earnings upgrades to downgrades has dropped from 1.7 to 1.2. The current reading is still above unity, though the pace of decline is of concern.
Regionally, recent earnings revision activity in the US has seen the ratio drop from 2.1 to 1.4, the ratio in Europe has declined from 1.8 to 1.3, and the Japanese ratio has slid from 1.9 to 1.4. The current reading for Asia excluding Japan, at 0.7, is consistent with an imminent decline in corporate profits. It is clear that global earnings momentum is set to register a meaningful slowdown in coming months, and investors would be well-advised to take note.
It is still too early to state categorically that the cyclical bull market is over. The recent move in the SP500 back above its 200-day moving average suggests that investors remain unconvinced by double-dip fears.
However, an inflection point has been reached, and it is highly unlikely that investors will replicate the dash for trash that was all too apparent last year.
The slowdown in earnings momentum, higher credit spreads and heightened market volatility all suggest that investors’ preferences will shift away from low-quality cyclical names to higher-quality issues with relatively predictable earnings.
The Kennedy slide of 1962 did not spell the end for the economy’s upward trajectory, but it did herald the demise of low-quality stocks with dubious prospects, as investors increasingly emphasised blue-chip names, given their relative stability and attractive valuations. The same should prove true today given the inviting relative valuations of high-quality growth stocks, which are trading at the lowest price/earnings multiple premium since the early-1990s.
Investors should think quality.
www.charliefell.com
