Job Jitters

After notching its 5th all-time closing high for the year on Monday, March 2, and its 103rd of this bull market, the S&P 500 awoke with a hangover from Post-Nasdaq Euphoria, then succumbed to a case of job jitters, slipping 1.6% on the week. On Monday, March 2, the Nasdaq Composite closed above 5000 for the first time since 2000. Many rejoiced following this recovery but questioned why it took so long. Maybe the question really should have been “Why so fast?”

The Nasdaq tumbled 78% from its closing peak of 5048.62, on 3/10/00, until its ultimate low of 1114.11 on 10/9/02. By comparison, the Dow Jones Industrial Average fell 86% during the Great Crash of 1929, but required 25 years to get back to breakeven. Now investors are asking “Does the speed of this recovery imply that a new tech bubble is brewing?” Hardly. Using the S&P 500 Tech Sector Index as a proxy for the tech-heavy Nasdaq, today the tech sector’s trailing 12-month P/E of 18X compares very favorably with its P/E of 66X back in Q1 2000.

The equity market’s response to the increased likelihood of a June rate hike indicates just how nervous Wall Street is toward rate-tightening actions by the Federal Reserve. History explains why. Since 1946, there have been 16 times that the Fed started a rate tightening cycle. In 13 of these 17 times, the S&P 500 suffered through or saw the start of six Pullbacks (declines of 5%-9.9%), four Corrections (10%-19.9%), and three Bear markets (20% or more) that ultimately declined a median 10.1%. Following the first rate increase, the S&P 500 slipped into six declines (two Pullbacks, two Corrections and two Bear Markets) that averaged 11.4%. Which of the three will it be? My vote is for a Correction.

The S&P 500 has gone 41 months without a decline of 10% or more, as compared with a mean of 18 months and a median 12 months since WWII. A 10% decline from the recent all-time high would push the S&P 500 down to around 1900. We don’t think a bear market is likely as the yield curve is still quite accommodative and causes other asset classes to be much less attractive. Plus, if investors are concerned by the strength of the jobs market, they are likely underestimating the health of the U.S. economy, which was recently reported to have expanded by only 2.2% in Q4 2014.

Full-year 2015 real GDP growth will therefore more likely approximate 3% rather than 2%. In addition, the S&P 500 EPS growth forecast is probably also grossly undershooting its actual trajectory. As a result, the current 1.1% aggregate forecast of analyst 2015 e EPS estimates for the S&P 500 compiled by Capital IQ will likely see a gradual uptick in estimates, similar to projected daily temperature highs for the East Coast in the weeks ahead. Therefore, while it may be advisable to brace for a correction, one should also prepare for a recovery in what could ultimately allow this 6th year bull celebrate its 7th anniversary.

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