Sunday, January 30, 2011

Don't Blame Egypt

You can try blaming the rioting in Egypt, lower-than-expected GDP growth, and disappointing guidance from bellwether Amazon for Friday’s sell-off in stocks. Most likely, however, the real culprit was simply jittery investors trying to lock in profits from an extremely strong rally, which they suspect cannot last much longer.

In fact, as of Thursday’s close, the S&P 500 had surged 27% from its July 2, 2010 low. That is a great return for a full year let alone for just six months. The average annualized gain from equities is closer to 10% (including dividends). Rational investors know this pace is not sustainable. Given the severe sell-off in 2008 and into 2009 that followed the financial crisis, and the sell-off from 2000 to 2002 that followed the dot com bubble, many investors are exercising much more caution than they did in the 1990s. They want to make sure they don’t get caught in the next round of heavy selling. Of course, this does not mean that stocks will plunge. However, it could mean that prices remain flat for the remainder of the year.

Stocks have done great since hitting bottom on March 9, 2009. The strong gains in recent months were probably justified. After all, pundits like to say that the bottom line is the bottom line. In other words, in the final analysis, profits are the only thing that matters. And there is no question that corporate profit growth has been impressive. In recent quarters, we have been treated to better-than-expected earnings reports and decent year-over-year earnings gains. With earnings results like these, there is no reason why stocks should not have rallied.

Yet many problems remain. The federal budget deficit is too large and the government is carrying too much debt. States and municipalities are drowning in public pension obligations. The unemployment rate is improving, but much too slowly. Mortgage delinquencies and foreclosures remain too high, there are too many homes available for sale, and housing prices remain depressed. Worldwide inflation is on the rise. There are even problems at the corporate level. Yes, corporate profits are strong, but the same cannot be said for sales. Many companies are reporting anemic growth on the top line at best. Others continue to see revenues decline. Corporations are squeezing more profits from fewer sales only by aggressively cutting costs. This kind of cost cutting cannot go on forever. All businesses eventually reach a point where more profits can be produced only from more sales. Most are probably at that point already.

Academics like to say that markets are efficient, meaning that, on average, stocks sell for what they are worth. Yet even the academics recognize that markets are not perfect. Stock prices often go to extremes. When sentiment turns negative, prices fall well below what the fundamentals would dictate. When investors turn too bullish, prices overshoot on the upside. A 10 percent correction should not surprise anyone. In fact, a healthy sell-off should be welcomed by all long term investors who are holding cash that needs to be put to work.