Sunday, July 12, 2015

Mitch Zacks 2015

[7/19/15]  There’s a big piece missing from the Chinese ‘stock market mania’ narrative, and it’s probably the most important part of the story – explaining how China’s equities markets actually work!

The basic premise is that Chinese equities are divided into A-shares and H-shares. A-shares are available for trading almost exclusively by Chinese investors, meaning that the market is missing two critical components of efficiency: maximum liquidity and global participation. It follows that A-shares have virtually no correlation to global markets—one zigs and the other zags, one soars while the other only nudges higher.

It’s the A-shares that are creating all the hubbub in the press. Over the last year (through July 14), A-shares climbed almost +150% through June 12, then fell nearly 35% to their low on July 8. That’s the type of market activity investors are wise to avoid.

Chinese H-shares are a different story, and they matter more for the narrative. H-shares trade on the Hong Kong exchange, which is an open market where international investors can participate. The difference in the market action is astounding: H-shares went up a little over +40% to a peak on May 26, and have fallen about 20% over the last month or so. That’s eyebrow raising volatility, but it’s not an Armageddon-like swing many are now associating with China.

If you look at global stocks over the same period, you’ll notice that they have virtually no resemblance to Chinese equities, A-share or H-share. The MSCI World is essentially flat over the last year.

[7/12/15 Mitch Zacks] If you had just one word to describe the market so far in 2015, it might be: volatile. And, this can be concerning. Regardless, for all the market machinations, performance essentially finished flat eking out a 0.7% (S&P 500) gain. So, what do we think will happen next?

At first glance, the economic backdrop might raise eyebrows: a second estimate of U.S. GDP shows contraction of -0.7% in Q1 and incoming data point to a tepid rebound in Q2, perhaps +2%. Additionally, if you consider uninspiring domestic growth, an escalating Greece situation, the wild China stock ride and imminent U.S. rate hike(s), you might conclude the odds are stacked against a strong finish in 2015.

And, you may be right. But these factors are not enough to turn bearish for these four reasons:

1. Markets Tend to Do Well in Rising Rate Environments – the last three rate hike cycles have corresponded with strong market performance. In 1994 – 1995, the Fed raised rates 7 times and the S&P 500 annualized 18% in that period; in 1999 – 2000, there were 6 hikes and the S&P 500 annualized 5%; from 2004 – 2006, 17 rate hikes and 16% annualized on the S&P. It makes sense why this occurs: if the Fed is raising rates, it’s because the economy has underlying strength! Stocks tend to do well when that’s the case.

2. We Expect GDP Growth to Average 3% Over the Next Four Quarters – we expect earnings to recover and for the economy to expand at a moderate, but reasonable, pace. This should push unemployment down to 5.1% by the end of Q4 with core inflation, based on Personal Consumption Expenditures [PCE], creeping up to 2% by 2017. Not too hot, not too cold. With multiple expansion that has come with Fed easing the last six years, we think the market should move more in-line with earnings growth versus seeing P/Es climb much further. That could mean single digit S&P 500 growth in the next year or two.

3. Greece is a False Fear, Creating a Wall of Worry Markets Love to Climb – the Greece story is now over two years old, which means the market has had plenty of time to price-in the worst. Even if there is a “Grexit,” we think it’s probably only capable of inciting a bit of short-term volatility. All this talk of the European banking system collapsing or systemic issues surfacing (if Greece leaves) are over-reactions in my view. False fears are almost always tailwinds for stocks.

4. Global Growth Should Continue Apace – in spite of Europe’s Greece dealings, the region should see growth in the range of 1% - 2% this year, which is more than it has grown in a few years. Having Europe back in the plus-column is good for global GDP, and I think the U.S. and China will hold up in spite of the jitters that appear to be surfacing. China is willing to ease and the U.S. should recover in the back half like we did in 2014.

The Bottom Line for Investors

With the Fed tightening, modest corporate earnings growth, and a further decline in the equity risk premium, we expect the S&P 500 to notch up +4% to finish the year. While 4% isn’t the kind of return we’ve become accustomed to as of late, it still beats what you can get from U.S. Treasuries, or much of what can be attained in fixed income markets. And, the outlook for equities beyond 2015 remains positive with the possibility of upside surprises in my view. For the long-term growth investor, equities likely remain the best asset class for now.

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