Buy the dip once again prevailed. After one of the worst starts to the year ever, the S&P 500 has recovered to show a positive return year to date.
We continue to be in a counter trend (buy short term lows and sell short term highs) trading environment. Short covering, corporate buy backs (which accounted for over 50% of stock money inflow in Q1), rising oil prices and higher cash positions being put to use by mutual funds provided fuel for the recent stock market recovery.
The rise in equity prices has once again put the stock market valuations near all-time highs when looking at top line growth, the Tobin Q ratio, cash flows and other metrics. The last three times these valuations have been reached after a relief rally (September 2014, July 2015 and December 2015), the market has declined by at least 8% or more in the ensuing couple months.
The next correction may not happen until the summer months however. We’re about to kick off earnings season which should once again mimic the last couple quarters with top line growth persistently weak due to declining sales. That said cost cutting measures, corporate buy backs and non-GAAP earnings should continue to allow companies to beat on the bottom line given the lowered guidance.
Last month I pointed out the strong divergence in GAAP vs Non- GAAP earnings. David Stockman, former Director of the Office of Management and Budget under President Ronald Reagan, recently pointed out that GAAP earnings have already declined 18% from their peak levels, leaving the stock market trading at 22 times earnings. While this might be acceptable in a high growth market, it’s extremely overvalued on an historical basis
Alongside reduced consumer spending, higher auto loan defaults, reduced corporate profit margins and reduced earnings expectations, I don’t see how this won’t have spillover effect into the stock market. I have to reiterate that this does not mean that the market can’t go higher, it can. But in the medium term of 6-12 months the probabilities indicate another correction to the downside as we’ve witnessed 3 times in the last 18 months. I would expect this one to be at least 10% or more,