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Bronte Capital
Gordan Pape

Floating on Air

What to do in this stock market

July 17, 2016 | About:

The Dow and the S&P 500 hit new all-time record highs last week. That makes me very nervous.

I think these markets are floating on air. I can't see any solid underpinnings to this rally, nothing that can sustain the indexes at these lofty levels. A significant summer correction looks increasingly likely.

Stock prices have being driven higher by the some relatively solid U.S. economic numbers (287,000 new jobs in June), the decreasing likelihood of another Fed rate increase this year, and investors pursuing high dividend yields in a low interest rate environment.

Those are positive drivers, but there are many negatives that investors seem to be overlooking right now.

Let's start with the pricing. One year ago, the Dow Jones Industrial Average had a price/earnings ratio of 16.49. As of Thursday's close it was up to 19.67, according to The Wall Street Journal. It's the same story with the S&P 500, which was at 24.07 on July 8 compared to 20.6 a year ago. It's long-term average is about 16.7.

At these levels, U.S. stocks are clearly expensive. Without a price retreat, it would take several quarters of above-average corporate profit growth to bring the index p/e back into line. That seems unlikely. The S&P 500 reported four consecutive quarters of year-over-year earnings declines to the end of March. Analysts are predicting a further drop of 5.6% for the second quarter, according to the FactSet website. The site reports that to date 81 companies have issued negative earnings guidance for the quarter while only 32 companies have been positive.

High prices aren't the only problem facing the markets in the second half. In a conference call last week, three of Blackrock (iShares ETFs) senior analysts said world economic growth would likely be much slower than originally expected in the next few months, due in large part to Brexit.

The British vote to leave the European Community will have "a material impact on financial markets going forward," said Richard Turnill, Blackrock's global chief investment strategist. He said the decision has created a climate of political and economic uncertainty that will extend far beyond Europe. As a result, we should expect lower growth, more stimulus from central banks in Europe and Japan, and even lower interest rates than we're experiencing now.

"We are in a period of low returns and high volatility," he said.

The interest rate scenario is especially alarming. Right now, some $10 trillion in bonds carry negative yields. That means investors are paying governments and central banks to hold their money in safe securities.

Those low rates are prompting investors to reach for yield in the stock market, pushing prices higher. "Equity markets have effectively borrowed from the future," Mr. Turnill said. "We expect to see lower returns going forward."

Despite the gloomy outlook, there are some profit possibilities to explore. It's a matter of being selective. Here four that were identified by the Blackrock team.

Quality bonds. A continued drop in interest rates would push the prices of quality bonds even higher. High yield bonds could also move up more but their risk is higher because of the possibility of defaults in a slower growth environment.

Gold. It has done well in the current environment and investors who don't have a position should establish one for purposes of diversification.

Emerging markets. The Blackrock team sees profit potential in emerging markets. These stocks have been battered recently, with the MSCI Emerging Markets Index down 12% in the year to June 30. This was due in part to the currency risk created by the surging U.S. dollar. However, with the Federal Reserve Board expected to remain on hold for the rest of this year, the greenback should stabilize. With the currency risk negated, the low valuations of EM stocks look attractive.

Dividend growth stocks. Investors have been chasing stocks with high yields. Kate Moore, Blackrock's chief equity strategist for the Americas, says the focus should be instead on dividend growth stocks - companies that may not have a high yield now but which are positioned to increase payouts on a regular basis over time. "They will be the winners," she says.

Rating: 5.0/5 (1 vote)



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