Fourth-Quarter Equity Index Outlook with Nick Kalivas
October 2005
Where do you think the stock market is headed as the year draws to a close? Nick Kalivas, Vice President of Financial Research and Senior Equity Analyst with Refco Global Research, explored bullish and bearish arguments for the equity market heading into year-end in a live RefcoPCG webinar on October 5, 2005. He gave his thoughts on which direction he feels the market is heading, and discussed the impact on market direction of factors including energy prices, Federal Reserve monetary policy, and Hurricane Katrina.
The Bearish Case
First, Kalivas outlined the negative factors overhanging the market. The first is related to energy prices. He said that while crude oil prices have already created issues, the winter heating season could heat up prices in other energy products, natural gas and heating oil. These price spikes have not only hurt the consumer, but are starting to shut down some business activities. This is having an adverse affect on corporate profits, said Kalivas.
In addition, Kalivas said the impact of geopolitical risks (namely terrorism), is creating a wedge in the equity market that's preventing it from realizing what RGR considers fair value. "People don't seem willing to embrace the equity market given the current geopolitical environment," he said.
Then there's the Federal Reserve's continued tightening of monetary policy. Kalivas said the Fed has a "so-so track record" at creating soft landings, and one can look back to the tightening cycles of 1989 and 2000 for evidence. "There is a fear right now that the Fed will indeed over-tighten this time, and that will have an adverse affect on corporate profits and stock prices," he said.
In addition, Kalivas said there has been an increased use of "exotic mortgages," such as interest-only mortgages and adjustable rate mortgages. "I don't think the Federal Reserve or the market knows how to handle this increase in leverage by the consumer...it creates a downside risk," he said.
Profit growth has also been slowing and there are some indications the economy may be weaker than what is generally being reported by the media. Kalivas said RGR's leading profit indicators are showing deceleration of profit growth. And, he said the very successful employee discounts/employee pricing plans imposed by the automakers recently simply pulled demand forward. "We have this appearance of strength but will probably go into a payback period," he said.
Retail sales have also been generally soft over the last six weeks to two months, and retailers seem a bit on edge. Kalivas said this is confirmed by Wal-Mart's announcement that it is going to gear up discounting for the holiday season, and Best Buy's indication it would have weaker-than-expected profits.
Lastly, there are political risks relating to the fallout from Hurricane Katrina. Kalivas said most troubling would be an action putting the Sunset Provision on President Bush's tax cuts into effect. "We think the capital gains tax cuts, the lower margins rates, have been very supportive to economic growth. If they were removed it would be a negative," he said. In addition, governmental aid funneled to the Gulf Coast seems very large, prompting worries of potentially wasteful spending that might extend the Federal Reserve's tightening cycle.
The Bullish Case
Kalivas said the market's bullish factors are more long-term in nature, and largely based on valuations. Nonetheless, there are reasons to be optimistic. While it may be slowing a bit, corporate profit growth is still positive and the level of profits is still pretty high. At the same time, the 10-year Treasury note yield has been range-bound at a very low rate.
"We think if we look at the earnings picture and interest rate picture, stocks are extremely cheap," he said, adding this view is supported by merger and acquisition activity. M&A activity has been very strong for the first half of 2005, and although it has slowed a bit in recent months, so far the trend is positive. The supply has been light for first half of this year, but has picked up in the last couple months.
"We believe companies don't issue a lot of supply if they think their stock is cheap," said Kalivas. Dividends have been high and rising, and buyback activity has been strong. "The combination of all these factors has confirmed the argument the stock market is cheap, and confirms some of the statistical valuations...although we are a little bit nervous about the very recent trend," he said.
Taking a look at the performance of equities in other countries, the emerging world is really quite strong, he said, and that's lending a bit of support here at home. "When we look at consumer activity, we worry about weakness in the U.S. market, but in fact it looks like overseas growth is quite positive," he said.
A massive amount of money has been moving into the outperforming emerging economies. As of early October, the S&P 500 was up about 1.39 percent year-to-date, but the MSCI emerging Asia Index was up 13.81 percent and the MSCI Latin America Index was up 38.71 percent. These economies do well when commodity markets are strong because, in many cases, they are commodity producers. And, growth is fairly good overseas. For example, India recently indicated its second-quarter GDP rose 8.1 percent, and China is still growing, although not as fast. These factors are attracting money away from the U.S. market.
While this may at first seem like a reason to be bearish our market, Kalivas said he takes a contrarian viewpoint. "We think contrary thinkers should be bullish. The public is disinterested in the U.S. equity market; it is (investing) elsewhere. The (U.S.) stock market has posted a number of years of very poor returns."
He said not only has money flowed into emerging markets, but also commodities and real estate. Kalivas said as these investments show signs of cooling, investors are likely to take profits, and rotate back into U.S. stocks.
There's also a case to be made that the negative factors mentioned above are already factored into the market, so there may not be much more downside. "Everyone knows energy prices are high, and interest rates are going up," Kalivas said. "Can it get a lot worse?"
Sentiment readings are also often used as contrarian indicators. The idea is that investors can simply get too jaded, or too exuberant, and neither view may be justified. Kalivas said current sentiment indicators can also make the case that the market may be in for better days. "When bullish sentiment is low, the market tends to rally, and when it gets really high, that tends to signal a break...sentiment is very bearish right now," Kalivas said. Perhaps investors are too gloomy—so good news can quickly turn things around.
Buy S&P Futures on Breaks, or Breakouts
"When I look at all the factors, I see a lot of headwinds that are negative for the market. We have high energy prices. We have tighter monetary policy. We have margin squeezes. However, when I look at the valuation and cheapness of the market, I think you have to be compelled on a longer-term basis to look for places to buy," Kalivas said. He recommends buying S&P 500 futures on a breakout of the recent range to new highs, or a pullback into solid support areas, with a manageable risk.
"I do think valuations argue for the market to work higher—that's my general approach to the trade," he said. Traders should be forewarned that on a day-to-day basis, there are plenty of negative factors that could pull the market down. He feels these pullbacks should be viewed as buying opportunities.
To view Kalivas' full presentation, including various charts and graphs with more detailed market analysis, go to our Events archives area. It's free to view, but you must register first if you haven't done so already. You can also find more specific trade recommendations from Refco Global Research. RefcoPCG clients can sign up for a free two-week trial.
Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.
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Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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