Since the outset of 2010, we have remained in the optimistic camp about the outlook for the economy, profits and the stock market. We have believed the economy would grow, profits would strengthen, and the markets would remain in a cyclical bull phase. Presently, we remain hopeful about these trends, but hope is insufficient when the fundamentals and technicals of the market are shifting.
The economy’s growth is slowing and many economists have recently revised their expected growth downward to 2.5 – 3% for 2010. While this outlook is not that bad, it is not enough growth to excite the market, especially when participants continue to worry about a double dip in the economy. More importantly, analysts’ estimates of profits for 2011 appear optimistic. Companies will be getting progressively less benefit to margins from cost cutting and profits growth will become increasingly dependent upon top line revenue growth. Unfortunately, most second quarter profits reports are either not evidencing any revenue growth or very little top line gains. As the economy’s growth moderates to a sustainable rate of increase, we believe that meaningful revenue gains are going to be more difficult to achieve. This difficulty may be made more acute if pricing remains competitive or becomes even more competitive. Especially worrisome is the emergence of signs of deflation in the U.S. and Europe. If deflation becomes more evident, both consumers and corporations are likely to be reluctant to spend cash and may even desire to hold more cash, thus exacerbating the tendency toward deflation.
The market technicals have been deteriorating for some time. This deterioration may be reflecting concerns about future profits growth and even deflation. In any event, the technicals suggest the S&P 500, now at 1067, could fall below 1000, perhaps to 875 – 900 in the months ahead. Traditionally, the stock market weakens in August and especially in September and October.
With the fundamentals shifting and the technicals weakening, we advise lowering the volatility of portfolios through the sale of equities tied to the more volatile areas of the market, such as small, mid cap, and emerging markets. Raising some cash as insurance against a possible further market decline is a prudent action at this time.
A. Marshall Acuff, Jr., CFA
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC