Potential upcoming correction could be opportunity to buy stocks

SINGAPORE (June 12): Bank of Singapore analysts Eli Lee and Conrad Tan believe the halt in the US stock rally on Friday could be part of a bigger pullback.

Corrections above 10% occur frequently enough, and investors could take time to re-look at valuations to evolving market risks, they say in a Friday report.

“This pullback so far is characterized by a sharp reversal of the rotation into Cyclical and Value, which has been in place over the last couple of weeks, but we see the Cyclical/Value rotation re-asserting itself if the economic recovery does pan out over the medium to long term as anticipated,” say the analysts.

Notably, Lee and Tan see the pullback as an opportunity to add “structural long-term winners” on attractive valuations.

Cyclicals and value stocks with resilient balance sheets will, over the long term, benefit from the economic recovery, they say.

“In the near term, we do not see systemic selling to be a serious concern for equities as yet,” they say, noting that the market does not appear to be underhedged at this point.

“Only if the correction deepens further significantly, would we see systemic selling triggered at funds employing strategies such as CTA and risk parity,” they add.

The recent spike in Covid-19 cases in the US has led to concerns of a second wave of infections.

While the situation remains to be seen, Lee and Tan believe that the economy will not be as heavily impacted, should subsequent waves of infection occur, as the public and policy-makers are now more aware of the nature of the virus. Therefore, full shutdowns, as seen in the earlier parts of the year, are unlikely, they say.

Lee and Tan also believe that the equity market is unlikely to bottom out to the levels in March, which reflected greater levels of uncertainties.

“[The market free fall] includes the real risk of a greater financial blow-up stemming from the tremendous liquidity pressures at that time, which is now mostly diminished,” say the analysts. Lee and Tan say that the search for yield is expected to be a powerful market driver in this environment. As such, they have an “overweight” position within their asset allocation strategy on Emerging Market High Yield bonds.

“As valuations become more attractive alongside this sell-off, we will look to add exposure to selective attractive opportunities in this space,” they conclude.

V-shaped recovery likely, but correction likely first: Morgan Stanley 8 Jun 2020

Since late March, I've taken an optimistic view of equity markets for the following reasons. First, bear markets end, rather than begin, with recessions. Second, the health crisis that triggered this recession has brought unprecedented monetary and fiscal stimulus that would otherwise have been impossible. Three, the political pressures behind the reopening of the U.S. economy are likely to make it faster and more durable, even if a second wave of the virus emerges. Four, sentiment and positioning have remained remarkably bearish considering the size and persistence of the equity rally to date. And finally, index prices, the equity risk premium, market breath, and early cycle leadership are all following the same pattern we witnessed at the 2009 bottom during the Great Financial Crisis. In short, our recession playbook is working.

Having said that, a few signals have been missing that would support a continued bullish outlook for equities. Specifically, the U.S. dollar has remained strong and the 10 year Treasury yields remain depressed. While one could argue that a strong U.S. dollar benefits U.S. equity markets through flows and lower interest rates support valuations, our contention is that both are bad signs for the economic recovery. Therefore, we were glad to see both a weaker dollar and higher back-end rates last week, even before the stronger jobs data were released on Friday morning. In fact, both have moved above some key resistance levels left over from April. This combination provides a missing signal for two critical macro markets that a V shape recovery is, in fact, looking more likely.

It also matters because we continue to hear concerns from investors that equity markets appear disconnected from reality. One argument in support of this view is that longer term Treasury yields haven't budged and the bond market is smarter than the equity market when it comes to forecasting the economy. However, a good part of my investment framework is based on analyzing the internals of the equity market-- in other words, how sectors and styles and factors are behaving, rather than just looking at the headline index. These signals contain a tremendous amount of information, and I've found them to be helpful in forecasting real economic activity. One of my favorite stock ratios tracks how cyclical stocks trade relative to defensive ones. This ratio has been an excellent leading indicator for economic growth, often better than Treasury yields.

In 2018, for example, this ratio proved to be timely in calling the peak rate of change in the U.S. economy. It even foreshadowed the top in long term interest rates at a time when the consensus was bearish on Treasury bonds. In other words, equity market internals did a better job than the bond market in calling the top of the economic cycle. Now we find ourselves in the exact opposite situation. The stock market is rallying strongly, led by cyclicals. However, bond yields have lagged and failed to confirm the signal from stocks until this past week. The divergence between our cyclical and defensive equity ratio and the 10 year yield hasn't been this wide since 2018, right before yields unexpectedly collapsed. Could this be the turning point for 10 year yields to move sustainably higher at a time when the consensus least expects it? Based on our interpretation of the equity market internals, there's a good chance it is. We also think sharply rising yields could have implications for equity portfolios, and the kind of rise in yields suggested by our cyclical defensive ratio would qualify as sharp.

If interest rates quickly catch up to cyclical stocks, it may be a temporary negative for equity indices as valuations come under pressure. Such a rerating would likely be most damaging to the bond proxies like utilities and consumer staples, and the most expensive growth stocks which make up a large percentage of the index. However, after a period of adjustment, a move higher in rates should ultimately be interpreted as another sign of better growth to come. The bottom line, equity markets have been telling us growth is going to surprise on the upside. Interest rate markets have lagged this move in equities, but could quickly catch up. A sudden, sharp move would likely cause a correction in the equity market, but I'd view it as just a bump in the road of this new bull market and an opportunity to add risk, especially in the more economically sensitive areas that have been leading.

Wharton professor Jeremy Siegel lays out why a record-high stock market in 2020 remains 'a real possibility'

Wharton finance professor Jeremy Siegel still sees a scenario where the stock market breaches new highs before the year is out, despite reopening risks, historic unemployment, and a deep recession.

The Federal Reserve's multitrillion-dollar relief operations offer an unprecedented lift to the recently struggling market and should aid in a run-up through the rest of the year, he added. Couple the hefty stimulus with investors' growing appetite for long-term risk, and stocks could rally to fresh highs before 2021 as buying picks up, Siegel said.

"Believe it or not, it is a real possibility. Given no serious second wave, which could mean just effective therapeutics without even a universal vaccine, my feeling is it's even a likelihood that we will reach it," he told CNBC on Tuesday.

Siegel's comments arrived during a strong market upswing. Investors piled into equities throughout Tuesday as optimism toward reopening efforts grew. The S&P 500 breached 3,000 for the first time since early March before closing just below the threshold.

The Wharton professor said the market's late-March low marks a floor for equity prices unless the coronavirus pandemic flares up again. Stocks' rally through the lockdown could prove too powerful, he added, as the larger firms included in major benchmarks likely performed better than smaller businesses.

"One of the unfortunate things about the lockdown is we've actually improved the prospects of the very companies in the stock market," Siegel said. "We've widened the gap between large and small, and between those people feeling the pain and those people that have their portfolios."

One factor Siegel is less concerned about is the Fed's stepping back from emergency lending. Several market experts see a market correction on the horizon once the central bank unwinds its nine credit facilities and stops its backstopping of the credit market.

The professor expects the Fed's retreat to take place over a long period of time to ensure a steady recovery. As long as that cash remains in the financial system, the economy will likely enjoy a brief bout of healthy inflation, he said.

"There's no way they're taking that back, and as a result, that is all going to be flowing into the stock market and the economy," Siegel said.

(published 27 May 2020)