Prolific, controversial, and opinionated Barry Ritholtz is one of the most widely read asset managers and hedge fund critics. His recent article on a coming correction has struck a chord with many investors, and may even have had a marginal impact on the S&P 500, which turned south in the first two days of trading.
The article is worth reading, but can be summed up as follows: corrections happen, they are normal, they are unpredictable, and they should not be the focus of investment decisions. The asset manager’s ideal solution to market corrections is that they are great rebalancing opportunities; when a correction causes a trend to slow or temporarily reverse, it’s a great time to take action.
There is wisdom in this deliberate and contrarian strategy. So far, SPY has returned 6% YTD, but it has returned 10% since dipping in February, when some commentators were pessimistically pointing to China’s moribund PMI numbers, the freakish winter weather in the U.S., and Europe’s inability to stimulate its constituent economies.
Those motivated by fear who sold then lost out on the 10% gains since then, while those who bought amidst those fears has yielded better-than-indexing performance, or that ever-elusive “alpha”.
Whether the performance of the last two days is the beginning of a correction or a two-day long hiccup is impossible to predict. But if a correction is coming, it is coming at a good time. Alcoa (AA) announces its earnings after trading on Tuesday, which will kick-start second quarter’s earnings season.
Expectations for AA are extremely high, but even if it shows strong but not above-expectations growth, it could possibly stop this correction (if this is one) in its tracks. If it doesn’t, then traders will need to work hard throughout the earnings season to correlate their purchases with what companies are reporting.
There are two ways to do this: first, traders and analysts will need to track top-line and EPS growth, measure them against expectations, and identify whether companies are growing their way out of the sluggish U.S. economy we have seen since 2009. Failing that, investors will need to see if companies are using financial engineering to return more capital to shareholders that will keep the overall market’s P/E at its moderately high position even if the P/S ratio climbs higher.
Secondly, traders will need to examine companies’ forward expectations and how they compare to Wall Street’s forward look. First quarter’s economic contraction has been discounted as a weather-related phenomenon by most institutional investors; as a result, expectations are high. Investors will need to see if management shares the overall optimism that has driven investors back into stocks since the dip in February.
In short, the market’s momentum and whether it goes into correction territory is going to depend on what happens with earnings. This is a good thing. For years, stocks have broadly followed the vicissitudes of the Federal Reserve’s monetary policy and the U.S. Government’s fiscal policy. If market fundamentals begin driving the stock market, whether up or down, it will also mean that analysts can do a much better job of accurately allocating capital to winners while avoiding losers, and stocks will begin to correlate more closely with their growth potential than with larger macro policies.
It should also be noted that this has been the Federal Reserve’s goal for years now, and with the taper in its final months, the Fed may be getting its wish.