U.S. Stocks Correction Fear Fades Despite Valuation Angst

A rapid recovery in U.S. stock prices after the recent slide may be enough to make many investors who remained bullish feel a little smug. That would be a mistake, market strategists say.

Investors should instead take the emerging markets scare that drove stocks down about 6 percent at the end of January as a warning of more risks to come. Things have changed from 2013, they stress, and this is no longer a market that will lift all boats indiscriminately. So playing some defense is appropriate.

Cantor Fitzgerald, for one, said it was considering new hedges at these levels. Peter Cecchini, global head of equity derivatives in New York, said markets would be "far more sensitive to bad news" in the current environment, which "presents a new volatility paradigm in which risk management will be rewarded rather than punished."

With few obvious justifications for stocks climbing further, investors are left in the position they were in at the beginning of the year: unsure about the economy and earnings, but facing an environment where few other assets offer the same potential return as the equity market.

Despite the rebound in the past two weeks that has taken the S&P 500 to within 0.5 percent of its all-time closing high, investors have been more circumspect in their approach. Trading volume on down days has far outpaced the action in positive sessions, indicating traders are more eager to unload shares than chase gains.

Investment flows have followed a comparable pattern, according to Lipper's fund-tracking data. Investors returned money to equity funds in the latest week, adding nearly $6.9 billion in the period ended February 12, but that pales in comparison to the more than $22 billion yanked from stock funds over the previous two weeks.

In another bearish sign, margin debt hit its fourth straight monthly record in December at $444.93 billion, according to Thomson Reuters data, a factor that has historically preceded market pullbacks, including shortly before the pre-financial crisis top in July 2007.

Increased debt creates the potential for margin calls, which occur when securities purchased with borrowed money fall below a certain value, forcing the investor to sell assets.

For sure, U.S. stock investors are giving the economy the benefit of the doubt for now, with some weak economic data being pinned on the arctic weather and heavier-than-normal snow storms that have gripped much of the country.

But if the data for such indicators as payrolls and industrial production doesn't improve as spring approaches, patience may soon run thin.

"We need to see pent-up demand released, come late March or the spring," said Michael O'Rourke, chief market strategist at JonesTrading in Greenwich, Connecticut. "If we don't see some kind of bounce back, then people should be concerned."


The conditions aren't as bleak as the weather.

Emerging markets have calmed somewhat, though they remain on edge, particularly in countries suffering from political turmoil or weak budget and current account profiles.

U.S. lawmakers signed off last week on an extension to the U.S. debt ceiling without much fuss - removing some political uncertainty.

And some metrics indicate that valuations have not become too stretched.

The S&P 500's forward P/E ratio of 15.2 is near its long-term average. The index's earnings yield - the inverse of the P/E ratio and a quick way to compare equity valuations with bonds - is hovering around 6.6 percent. That is slightly above the 6.27 percent yield of junk bonds, suggesting stocks remain a better value than their closest fixed-income equivalent.

In the fourth-quarter earnings season, more companies than average have topped analysts' expectations on both earnings and revenue, though those estimates came down before the season began.

In a sign of improving momentum, 56 percent of S&P 500 companies are trading above their 50-day moving average, up from about 25 percent on February 3, according to data from StockCharts.com.

"The strength in equities over the last few days, in particular, has been quite impressive, and certainly surpassed our expectations for any oversold bounce," Jonathan Krinsky, chief market technician at MKM Partners in Greenwich, Connecticut, wrote to clients.

Yet even if markets do avoid a pronounced pullback, the U.S. Federal Reserve's gradual pullback of economic stimulus through cuts in its bond-buying program may limit any upside.

Leo Grohowski, who oversees about $185 billion in client assets as chief investment officer of BNY Mellon Wealth Management in New York, recently affirmed BNY Mellon's year-end S&P 500 target of 1,900 to 1,950, the low end of which is less than 4 percent from current levels and is expected to come against a backdrop of modest economic growth and dividends.

"Valuations are not terribly exciting here," he said. "While bull markets don't tend to end with multiples in the mid-teens, it won't require much in the way of P/E expansion to hit our target."