Excessive Pessimism Is Currently Prevailing Despite The Improving Economic Backdrop
By Gus Krafve
June 4th, 2010
Certainly, the month of May has been the most volatile and worst performing month for the stock market since we embarked on this current 14 month recovery in equity prices, which began in March of 2009. We now have our first official correction since the March 2009 bottom, with the market down just over 10% from its April highs. Rather than continuing to focus on the recovering economic data, investors have become distracted by continued uncertainties in Europe and the oil spill in the Gulf of Mexico which began gushing on April 20. Not that some nervousness isn’t warranted given those uncertainties, but if we look at the bigger picture, the economic data continues to improve. Also, it appears the chance of the economy slipping into another recession in 2010 or 2011 is low.
Below are recent data points that continue to improve and point to a continued recovery:
• The manufacturing sector remains healthy and is still growing as reported by the ISM (Institute of Supply Management) number.
• The latest quarterly earnings reports from the 500 largest companies in the US showed continued strong growth with earnings increasing 21% on average.
• S&P 500 companies expect growth to continue for the remainder of 2010 and 2011 with earnings growing 17% and 14%, respectively.
• Real GDP (gross domestic product) growth will post healthy gains of around 4% for the first half of 2010, and leading economists are projecting 2011 GDP growth around 3.5%.
• For the better part of this year, the economy has been creating jobs versus eliminating them which has been the trend since early 2008.
These positive data points are important as it relates to stock prices. Research has shown over time the single most important factor to a rising stock price is earnings growth. Thus, a growing economy and corporate earnings growth bode well for rising stock prices. Another key component favorable to stocks is valuation. Currently, several ratios we analyze to determine if the stock market is undervalued, fairly valued or overvalued are indicating that stock prices are undervalued. This factor is important since the value of an asset tends to revert to its historical average over longer periods of time. However, it is important to remember that stock prices can remain overvalued or undervalued for several years. Using ratios to determine a stock’s value is a useful exercise, but it doesn’t mean that an investor will be immediately rewarded for buying an asset or asset class that is undervalued.
We are currently in an environment of excessive fear and pessimism. Selling stocks during periods of fear and pessimism has never proven to be a viable long-term strategy; and given the current backdrop, it appears the stock market has more upside potential than downside.
