Fasten your seat belts. The second quarter is expected to be a bumpy ride.
After a volatile first quarter for stocks that ended with the S&P 500 advancing a measly 1.3%, the broad-market index kicked off the second quarter on a high note. But experts forecast the second quarter will bring more volatility and possibly a long-awaited correction.
“I’ll go out on a limb and say I think [the correction] starts this quarter,” said Uri Landesman, president of Platinum Partners, a NY-based hedge fund.
“I’m not calling the end of the bull market. I still think we’ll see 2000 on the S&P 500 by the end of the year, first quarter of next year, but I think you could see 1600 first.” The S&P 500 recently traded at about 1860.
It’s been 30 months since the market declined 10% or more. But this quarter could break the trend if history is any guide. Data going back to 1945 show the S&P 500 posted its worst performance of the entire four-year presidential cycle during the second quarter of a mid-term election year, according to S&P Capital IQ. And the third quarter isn’t much better.
On average, the index declined 2.5% in the second quarter of a mid-term election year and 0.3% in the third. 2014 represents a mid-term year.
What’s more, the frequencies of price gains were weakest in the second quarter at only 47%. And the weakness stretched across large and small-size companies. The small-cap Russell 2000 clocked its two weakest quarters during a mid-year election year since inception in 1978, with average price declines of 3.5% and 6.6% in the second and third quarters, respectively.
“What unnerves me is that of the six times the market went longer than 30 months without a correction, four of those times we slipped into new bear markets rather than just a correction,” said Sam Stovall, chief equity strategist for S&P Capital IQ.
As the market moves into the sixth year of this bull run, volatility is also historically more inherent. Since 1949, equities have seen the second greatest amount of volatility in the sixth year, second only to the first year when most investors don’t believe we’re in the beginning of a new bull market.
History aside, the second quarter will be the real test for the stock market because the Street is expected to receive economic data and earnings that weren’t hindered by the weather. Severe winter weather coated much of the U.S. from January through mid-to-late-March, depressing economic data and hurting corporate profits in many instances, given a near-record number of profit warnings this season.
For that main reason, investors have glossed over disappointing data in the first quarter and are largely expected to give first-quarter earnings a pass. Profits among S&P 500 companies are expected to decline 0.6% in the first quarter, according to FactSet. That’s down from expectations for a 4.2% rise at the beginning of the year and would mark the first drop in earnings since the third quarter of 2012.
Meanwhile, economists forecast growth in the first quarter climbed slower than the 2.6% annualized rate in the fourth quarter and far below the 4.1% in the third quarter. Goldman Sachs is currently forecasting growth of just 1.3% in the first quarter.
In the second quarter investors will finally understand whether the economy and earnings growth weakened in the first three months of the year on account of cool weather or if there is more at play. A pick up in the economy will be critical for the bull market to continue. Everything from auto sales to construction activity and manufacturing will be key barometers to understand whether the economy is bouncing back.
“Excuses are over. Now [companies] have to produce and we’ll see if they can,” said Platinum Partners’s Landesman. “At 1872 the S&P is discounting a lot of good news. Valuations are very stretched, particularly if you have lower growth assumptions than consensus.”
As of the end of the first quarter, the S&P 500 traded at 15.2 time the next 12 months earnings, according to FactSet. That compares with an average of 13.2 times over the past five years and 13.8 times for the past decade.
Take a Cue from the Bond Market
Smart stock investors might do well to take their cues from the bond market. Since the depths of the financial crisis, if you wanted to know the stock market’s next move, you’d look to the bond market. Right, now the yield on the 10-year U.S. Treasury bond is treading around 2.7%, below the 3% level seen back in December when the Federal Reserve first announced plans to begin scaling back its bond purchases.
More so, the yield curve is flattening, indicating that the bond market doesn’t see the catalyst to push economic growth higher in the quarters ahead.
“With sales projected to grow 3% to 4% and earnings growth expected to be twice that, I think the bond market is saying ‘I don’t believe it,’” said Stovall.
Both sales and earnings projections will likely need to come down because there’s generally still a lot of debt the economy needs to work through. Also, companies are sitting on five times the amount of cash they had on their books at the start of the millennium, according to Howard Silverblatt, S&P Dow Jones Indices senior index analyst. While expectations are for capital expenditures to double this year to 7% growth, that still leaves a lot of cash on the sidelines that’s not being invested in new equipment or used for hiring, which holds back growth.
Then there’s the Federal Reserve: Its easy-money policies have been the key elixir behind much of the bull-market run to date. But the central bank is on course to wind down its bond purchases by the fall. The old adage don’t fight the Fed has worked well for investors. Now that the Fed is slowing winding down its stimulus – emphasis on slow – volatility has picked up.
Rookie Fed chair Janet Yellen caused a bit of a stir after the March Fed meeting when she implied the central bank may move to raise short-term rates from historic lows faster and more aggressively than investors thought. However, the good news is this looks like it will be a long, drawn-out tightening cycle.
Rates are coming from such a low base that contingent on the Fed’s median forecast for 2015, short-term interest rates at the end of next year will only be at 1%. That’s a small increase from a 0.75% median estimate in December. Further, in a recent speech, Yellen took pains to reinforce the notion that the economy requires continued support and that the Fed won’t back away from its low interest-rate policies given that unemployment remains high. Additionally, minutes from the Fed’s March meeting indicated Fed officials had not become inclined to raise rates faster. Bottom line, by the time the Fed starts raising rates, few investors should be surprised.
What’s An Investor to Do?
With volatility likely in store this quarter, it’s time for investors to get defensive, according to analysts. That doesn’t mean go to cash. Rather, investors should stock up on companies that tend to be insulated from market volatility and downdrafts – stocks that can continue to rally or at least not fall when the rest of the market drops.
Investors’ best bets are consumer staples and health care. Since 1970, consumer staples and health care are the only sectors that posted positive total returns during mid-term election year second quarters, according to S&P Capital IQ. Financials, technology, telecommunications and utilities were the weakest performers during that timeframe.
Even better, S&P Capital IQ’s Stovall found that by investing in health care and consumer staples in May through October and rotating back into more economically-sensitive stocks from November through April, investors would have added three percentage points to their return each year while also reducing volatility in their portfolios.
But even within health care and consumer staples, investors may not get away by simply gaining exposure to the sectors at large. Even these sectors have run up and success will hinge on individual stock selection. Michael Mussio, managing director for FBB Capital Partners, is scooping up snack-food giant Pepsico (NYSE:PEP) and pharmaceutical veterans Pfizer (NYSE:PFE) and Bristol-Myers Squibb (NYSE:BMY) for their juicy dividend yields, strong cash flows and robust balance sheets.