News Analysis date published New: 
Monday, May 7, 2012 - 11:30
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Monday, May 7, 2012 - 12:04
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Monday, May 7, 2012 - 11:30

Could the Stock Market Stumble Badly in the Summer?

Monday, May 7, 2012 - 11:30am

A bold start, a mid-year slump, and a superb finish... That was how the market played out in each of the past two years. Could the current year be shaping up to bring more of the same?

Consider these numbers...



The market gyrations in 2010 and 2011 were caused by the same factors. Early in each year, the economy began to look a lot healthier, though by late spring, the economy began to steadily weaken. Investors eventually got spooked, and the sell-off accelerated into the summer until investors realized that stocks had moved deep into bargain territory -- despite any economic concerns.

Unfortunately, a similar economic pattern appears to be setting up in 2012.

Roughly two months ago, I cited three distinct economic indicators that can give a read into the changing economy. The subsequent data points are surely sobering.

In mid-April, the National Federation of Independent Business (NFIB) noted that small business optimism dropped for the first time in six months. The NFIB pollsters noted that a similar drop was seen a year ago, which presaged further weakness to come -- along with a sharp stock market slump.

The Chicago Fed National Activity Index (CFNAI) has also weakened. The index had read a healthy +0.65 in December, 2011, but slipped to +0.38 in January and +0.07 in February, before falling to -0.29 in March. It ultimately fell to -0.70 this past summer, so the index bears close scrutiny in coming months. (Data for April will be released in late May.)

Notably, each of these economic measures eventually rebounded nicely, which highlights the tenuous nature of an economic rebound. An economy tends to strengthen in fits and starts and rarely makes a linear move. Investors were heavily spooked by the weakening economic data in 2010 and 2011 as it appeared as if the U.S. economy was just a few short steps away from a fresh recession.

These days, no such concerns are not on the horizon. Employment levels, the housing sector and the banking system all look a bit healthier these days, and coupled with ongoing robust corporate profits, the economy is now on terra firma. And actually, if you look back to a year ago, you can understand why the market eventually got spooked. Beyond the tepid economic data points that were rolling in, the Arab Spring created an unwanted sense of instability for the global economy, Japan's earthquake looked to trigger an economic crisis with global ramifications, and global food inflation was starting to spark protests in many countries. All of those factors eventually proved to have less of a global impact than had been feared.

What about Europe?
The market's periodic pullbacks over the past few years have also been attributed to concerns about an economic implosion in Europe. Indeed, the continent may end up back in crisis mode again this summer if the current trend of rising unemployment persists. But U.S. investors have recently concluded that European troubles simply don't matter. Corporate profits in the first quarter of 2012 have been quite robust despite the drag that Europe creates. In effect, the United States has decoupled itself from Europe's economic mess -- for now, at least.

Push or pull: Which will it be?
Economic trends tend to play out over a number of months. So the recent signs of economic weakness are likely to persist. Indeed, in the last few years, we've seen economic waves, as many months of positive data are followed by an extended period of economic weakness. So the market is surely at risk of a downgrade in expectations for GDP. Right now, the U.S. economy looks set to grow closer to 2% this year, rather than the 3% figure that some had anticipated just a few months ago. And frankly, 2% economic growth is nothing to be excited about.

The fact that the yield on 10-year Treasuries has fallen from 2.4% in mid-March to a recent 1.9% should also give you pause. Investors only bid up these bonds when the economic outlook grows cloudy.

Yet the outlook for corporate profits represents a huge counterweight to that tepid economic view. Analysts have failed to raise second-quarter profit forecasts even after first-quarter results mostly came in ahead of plan.

Valuations still matter
Yet there's another, more potent reason why you shouldn't expect a sharp market drop this time around. Compared to the spring of 2010 and 2011, stocks are now less expensive. In May 2010, the S&P 500 traded for 17 times trailing earnings. That figure stood at 15 in May 2011, and is just 14 today. Said another way, stocks traded for around 13.5 times projected earnings in May, 2010 and 2011, but that figure now stands below 13. That doesn't make stocks a screaming bargain, but creates a backdrop for bargain hunters if the market pulls back 5% to 10% from current levels.

Risks to Consider: One of the key market challenges for 2010 and 2011 were a series of unexpected events such as the Japanese earthquake. Any fresh scares could easily lead to a quick market drop.

Action to Take --> The current backdrop calls for a modestly defensive posture. Focus on stocks with low valuations, and you'll sleep a lot better at night. More importantly, this is a good time to have cash in reserve. Recall that the market falls a lot more quickly than it rises, and in light of the subsequent dip-buying that would likely take place, you want to be able to move quickly to snap up bargains.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.