Was the stock market's sharp upturn to end November a sign that the traditional December rally is on its way? In an e-mail discussion, David Parkinson asks three experts to weigh in on the possibilities – and the risks.
Paul Atkinson, head of North American equities at Aberdeen Asset Management, joins Brooke Thackray, research analyst at JovInvestment Management and Keith Richards, portfolio manager at ValueTrend Wealth Management, to debate the issue.
David Parkinson, The Globe and Mail: Do you think conditions are in place for North American equities to stage a meaningful year-end rally?
Paul Atkinson: Huge macro headwinds persist and that's been the focus since July, but economic data since September suggest underlying resilience is greater than people expected. Things are still poor, but not as poor as people may think.
Added to that, U.S. third-quarter earnings season showed that corporate performance is holding up well and profitability remains at elevated levels. … Of course, the risks remain on revenues and the lack of growth, but a lot of companies have already learned to live in such a tough environment.
U.S. equity remains a very unloved asset class after a decade of [near]zero returns, and the political deadlock that dominates the headlines means investors are very wary and under-invested. That backdrop of deep cynicism can often lead to a surprise rally.
Keith Richards: I am reasonably short-termed bullish, but longer-term bearish. Clients are asking me if a short-term rally can still occur in light of Europe, China, U.S. situation(s). My answer: Markets can rally in the near term because the leaders of the European Union (which is the main wall of worry of late) have no choice but to quickly come up with a debt "remedy." I use the word remedy with some trepidation – but the market's propensity to react to news more than fundamentals lately will likely push a strong rally upon any announcement(s) perceived to be positive.
Perhaps the announcement [on Nov. 30]of central bank co-operation was that catalyst. One cannot argue with the movements by world stock markets after [that]announcement, as the S&P 500 blew through overhead resistance of 1,220. But we will need a follow-through rally through the next, and more significant resistance level of 1,260-ish (which also contains the 200-day moving average) before I would expect the move higher to materialize.
If we don't get enough news-driven momentum to blow through the 200-day moving average and 1,260 resistance levels shortly, I would suggest that level as the top for this year.
As for the TSX – the chart is a disaster. It's barely above the 50-day moving average, nowhere near the 200-day MA and the trend is decidedly down. It will follow the S&P 500 up if/as/when that happens in the next few weeks, but will fall harder when markets turn back down later in the New Year.
Brooke Thackray: Typically, December is a strong month for the markets. For the S&P 500, from 1950 to 2010 December was the best-performing month, with an average gain of 1.8 per cent. and positive [returns]77 per cent of the time. It is usually best to err on the side of bullishness during this month.
The market has had a strong rally at the end of November, pushing it close to the resistance level, which currently lies in the same range as the 200-day moving average (1265). Although this makes it harder for the market to move forward, the seasonal trend is still favourable.
Now that we are out of earnings season, it is the economy and the macro-economic environment that is going to largely drive the markets. In the short term it is difficult to predict the European rescue packages, possible downgrades to countries and possible downgrades to banks. It is also difficult to predict the market's reaction to these events. … Having said that, after last week's co-ordinated central bank efforts to help Europe, some of the market's short-term headwinds have lessened, setting the ground work for positive returns in December.
DP: Based on valuations, do stocks look cheap now?
BT: The market is fairly priced by historical standards, sporting a 14 [price-to-trailing-earnings ratio]for the S&P 500. The question remains: Is this attractive given the current economic environment? The answer is that it can move much higher or much lower depending on how the situation unfolds in Europe. The U.S. economy is showing increasing signs of better health and if [the]Europe issue was taken off the table, the U.S. market would probably move higher from this point. Although using P/E ratios for long-term forecasting may be of some use, in the short term they are not helpful. Other shorter-term [technical]indicators … point to a market that is fairly valued, with upside opportunity.
PA: Assessing valuation across large-cap stocks is certainly more art than science. I prefer to look at forward [12-month]earnings estimates, which are above long-run historic earnings-per-share [EPS]growth rates of 5 to 7 per cent. Our work suggests that level of EPS growth is very achievable, and we're being asked to pay 12 times forward earnings, which compares to 14 to 15 times [at]the historic norm.
Throw in better-than-average return on equity and operating margins, and you can make the case that the market is below fair value. As Brooke said, though, the assumption here is the macro backdrop remains stable, because valuations certainly aren't at trough levels. Trough valuation would be more like 10 times forward earnings, hence the concern about the macro.
KR: Valuations don't seem to matter right now – the crowd is violently rotating between pessimism and (short-term) bouts of optimism. The crowd fears Armageddon – and cares less about whether the S&P 500 is trading at a good multiple right now. … I think that's going to be the case for the next while.
What I've found to work very well lately is watching sentiment indicators, such as put/call ratios, for signs of "deep disparity." Sentiment tends to be a contrarian indication of when investors have become too bullish or too bearish. Combined with momentum indicators that show you if markets have moved too fast in a given direction, you can get a reasonably accurate indication of what's to come in the near term. [Prior to last week's rally] conditions were oversold – now we're no longer oversold. So it's going to be up to the news flow to push it further.
PA: The one assumption that seems to go unchallenged at the moment (much like U.S. house prices were assumed to be forever on an upward path) is the risk of a sustained slowdown in China. The idea that China will deliver minimum 7 per cent GDP growth in perpetuity is rarely questioned [but]it is inevitable that the economy will experience slower and more volatile growth in future. Given China is the world's global growth engine, the rest of the world would find it impossible to shrug off such a slowdown. A European recession, whilst very unhelpful, can probably be managed through by U.S. companies, who are conditioned to expect very moderate growth to come out of Europe.
DP: Brooke raised the point of the seasonal trend - that's one of his specialties. Paul and Keith, you didn't mention seasonality at all...you don't believe in it? (Brooke, feel free to defend your territory here...)
PA: The only seasonal trend that I would bet on is for fund managers to eat and drink more in Q4 than Q1.
KR: I am a big believer in seasonal trends. Particularly for the sectors – most of these are quite logical –for example the tendency for energy to move in late winter into spring as the "driving season" approaches, the tendency for gold to move prior to east/Asian wedding season, the tendency for technology to rally before holiday shopping and the technology trade shows.…
Having said that – I would agree with Paul's seasonal observations of fund managers. Can we trade this somehow? Hmmm …
BT: Fund managers eating and drinking more (trying to beat their benchmarks) in Q4 and Q1 help drive the markets up at this time of the year, but there are other influences that have a large impact. The seasonal trend of the Empire Manufacturing Index shows an average annual trend of strength at this time of the year and weakness in late spring and summer … Stock market analysts are also guilty of helping to drive the market up at this time. Being an optimistic group, in Q4 they start to make strong positive forecasts for the next year. This carries forward into Q1 and into the beginning of Q2 before they start to become more realistic and often ratchet their forecasts down in the summer months. Another factor that tends to drive up the market at this time is the increased money flow into the markets from year-end bonuses … All in all, it tends to be a good time to eat and drink with the fund managers, and be in equities.
This discussion has been condensed and edited for publication.
David Parkinson