Market drop due to 'cracking' investor confidence, not recession Blog added by James J. Green on February 1, 2016
James J. Green

James J. Green

Joined: June 10, 2015

While past performance is no indicator of future performance, a knowledge of history and the difference between confidence-driven bear markets and recession-driven ones should remind investors — your clients — not to panic after Friday's continued fall in the equity markets. (The S&P 500 fell 41 points, or 2.1 percent, to 1880.)

That was the (paraphrased) message sent Friday, January 15 after the market's close by Brad McMillan of Commonwealth Financial Network, who argued that “the basic economics remain sound” and that “overall, the economic news isn’t grounds for today’s decline” in the markets.

McMillan, the independent BD’s chief investment officer, said in a prepared statement that while there “may be more short-term damage” to the markets than he thought initially, goes on to even-handedly make the case for why things might get worse, and why they might get better.

Proposing that since there is no economic news sufficient to cause a downturn, he lays 2016’s poor start to the markets to “cracking” investor confidence. Yes, the S&P 500 has “broken both its 200- and 400-day moving averages,” which he admitted “often suggests further weakness ahead.”

If we faced the threat of a real recession — when companies will “earn (and therefore be worth) less…scared investors will be willing to pay less for any stream of earnings. The drop in prices reflects this double whammy, and any recovery has to come from (1) an improvement in companies’ earnings prospects, and (2) a recovery in investor confidence. On average, this takes about 30 months.”

However, in confidence-driven bear markets, “company earning power remains as expected; all that erodes is the willingness of investors to pay up. That, historically, has taken less time to recover — about six months.”

Looking at the yields of the S&P 500 even if the index declined another 150 points or so, and assuming current earnings estimates, he argues that if an investor owned those 500 stocks, “at market value you would be making 7.4 percent in earnings. With bond yields where they are, that looks like an attractive investment and should draw investors back to the market.”

So what does McMillan see as necessary precursors for investor confidence to return? A belief that “those earnings estimates are correct.” Thus the importance of some companies beating earnings expectations — which they usually take pains to “lower in order to beat.” He thinks that “given the decline in earnings this past year, even modest improvement will likely allow for increases” in earnings. Another help would be rising oil prices, though low oil prices have historically presaged “a slowing economy.”

Additional confidence-boosting measures would come from more hiring in the U.S., which would raise consumer spending, and a demonstration by China “that it has taken control of its problems.”

All of those developments could occur over the next six months, he says.

McMillan thinks the best-case scenario painted above is likely, but warns that while the “current downturn may continue for a while” it will “ultimately burn itself out.” That is, as long as there is no recession.

Concluding, the pithy McMillan preaches that regarding the current market turmoil, “this, too, will pass, and it may not take as long as we fear.”

Originally posted on
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