Are Concerns About The Market Justified?

This is a common question voiced by concerned clients in the last few days. There is good reason for it, given that a highly volatile correction is underway. Recognize that the correction is more pronounced in the highest beta areas like biotechnology and social networking stocks, and in the exchange-traded funds (ETF) that reflect these in the Technology and Healthcare sectors.

Of course we are concerned about the markets. We are always concerned about the markets. With markets, the evolution of events can be shaped by exogenous shocks, but effects are limited if such shocks are contained. One of those is Vladimir Putin’s flexing of Russian might in Ukraine.

Another, and perhaps more important than Ukraine, is China’s slowing growth rate and the question of whether or not a meltdown is taking place in its credit system. China is the world's second largest economy behind the U.S. It is the world's largest goods producer so a slowing has vast implications for commodity pricing and for trade relations between China and other emerging markets countries. Let me quote a good friend and China expert, Michael Drury, Chief Economist of McVean Trading & Investments, LLC. Michael wrote this in today's letter. " The most recent trade data suggest that the deceleration is much more pronounced than the consensus is apparently willing to consider. Moreover, the confidence that the government can solve any problem is so pervasive that it can only lead to disappointment."

A third exogenous shock risk is the political unrest affecting the energy-related oil patch, including Libya, the Persian Gulf, and Nigeria. The external risk profile rises in this very important sector, and that elevated risk is reflected in an oil price that remains above $100.

Yes, we are concerned about the markets.

Let's examine a significant number that we have written about in the past. The average length of a bull market is about five years. But when all the bull markets since WWII are examined, not one of them lasted precisely five years. Some were much shorter, and others were longer – 7-10 years. There were really two groups. But there is not one example of a bull market that lasted the five year average.

That does not mean that the current bull market cannot end at the five-year mark. It started in March 2009 and could end in March 2014 at exactly five years. But we doubt that it will.

History shows that bull markets do not end because the calendar says, “Time’s up.” They end because of tight money orchestrated by a central bank that may be fighting inflation. Or they end because an external shock alters the economic composition and outlook. The central bank risk is the most important item to the US market. History shows that a Federal Reserve policy of easing does not trigger bear markets.

In the US, we do not have tight money. We have easy money. So the monetary reason for this bull market to end forthwith does not seem to apply. In 2014, we have gradual Federal Reserve tapering to neutral from a period of extremely easy money. That will be the case for the entire year.

We do have external shock risk. Ukraine is the smoldering situation that continues to command the front page. The others have been listed many times, so we won't repeat them except to note that a key official government report on China will be released on Tuesday.

When it comes to American stock markets, our view is simple. We are seeing a correction in an ongoing bull market. The bull market started in March 2009, and it is not over. The long-term upward bias in financial assets and other assets in the US remains intact. It will likely be intact for several more years.

Our expectation for the value of the S&P 500 Index at the end of this decade is somewhere between 2,200 and 2,500. At that time, we expect S&P 500 earnings to be somewhere in the vicinity of $160, maybe $170. We are expecting about $130 in 2014.

That is our outlook, and getting there does not require massively optimistic assumptions. It requires only gradual improvement and slow economic recovery over the course of the rest of this decade. And it is based on an assumption that external shocks will remain controlled or contained. Repeat: We are investing based on external shock risk being contained. That containment will result from (1) Putin limiting his actions to Crimea and Eastern Ukraine, (2) US energy sector expansion continuing and (3) China's government stepping up central bank stimulus in response to the slowing domestic economy.

For this end of decade expectation, we are looking ahead on an intermediate-term time horizon. We are not talking 20-40 years. We are talking 3-4-5-6 years. That is a reasonable, foreseeable, and attainable forecast term.

So, we remain concerned about the markets. Yes, of course, we are concerned. Meanwhile, we believe that this selloff is a correction, not a termination, of the bull market that started in March 2009.

We will incorporate lots of details in the forthcoming second edition of our book From Bear to Bull with ETFs.

BY David R. Kotok