The Stock Market: Reasons for Optimism

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 8, 2016 3:14:19 PM

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stock marketAs the market creeps back up, investors may be inclined to doubt the recovery. After all, there must have been a reason for the pullback we just saw. Couldn’t stocks drop again for the very same reason?

They might. As I often say, there's no shortage of risks. There are, however, a number of reasons to be more optimistic about the market. Let’s consider a few.

An earnings recovery may be on the way

The term earnings recession refers to a period of two or more quarters when earnings decline rather than increase. And yes, we’re in one right now. From a stock market perspective, this is a problem because what investors are buying is, essentially, a stream of earnings. When that stream flows less freely, the market should be worth less. Arguably, this is one of the major reasons for the recent pullback.

But the issue is more subtle than it looks, for two reasons.

Falling oil and the rising dollar were one-time shocks. The first reason is the cause of the decline—in this case, the falling price of oil and the big, sudden rise in the dollar’s value. Although the damage was real and substantial, it also lays the foundation for a recovery. Both of these factors were, in many ways, one-time shocks rather than ongoing headwinds. Oil, for example, is not going to zero and has already started to recover in price. Even if there is another interim decline, oil prices will normalize at some point. The same can be said for the dollar.

Because these are one-time shocks, the recovery—as we are seeing in oil—will reverse at least some of the damage to earnings as quickly as it caused it. In other words, this is not an earnings decline caused by slow growth, which could last indefinitely, but one brought on by a sudden shock, which could be reversed equally suddenly.

And we're starting from a lower base. The second point to consider is that, given the recent market declines, any such recovery will start from a lower base, making it seem even better. In other words, even a partial earnings recovery would look like stronger growth on a percentage basis. This is the mechanism behind strong recoveries from market pullbacks that don’t coincide with a recession, like the one we just had.

From a top-down market perspective, then, a substantial earnings recovery in the next couple of quarters is quite possible and could even lead to more price appreciation.

Potential opportunities to watch

Let’s also take a bottom-up look at the stock market. A lot has been written about the FANG stocks—Facebook, Amazon, Netflix, and Google—which have had a big influence on market returns recently. In fact, without these names and a few others, the rest of the market is down. By the same token, a great deal of the recent pullback was driven by those high-flying stocks returning to earth.

The upside here is that, while these stocks remain pricey, the average stock outside that small list isn’t very expensive at all. Rising earnings therefore stand to provide even more of a lift, even if the highflyers continue to take a break. Energy stocks and exporters, per the argument above, may be particularly cheap right now and could easily push the market higher if their headwinds normalize. Other sectors and stocks offer the same opportunity.

Overall, despite many legitimate concerns, there are also real reasons to be optimistic over the next couple of quarters. We’re certainly not out of the woods yet, but a number of structural factors are improving. Keep that in mind as you watch the market.

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