8 Reasons to Buy the Dip

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Zacks Investment Management  
10/12/2014

  
8 Reasons to Buy the Dip   

by Mitch Zacks, Senior Portfolio Manager

The market was under pressure this past week with the S&P 500 moving down roughly 3% over several sessions of relatively high volatility.

The major issue driving the selling is the concern that softness in global GDP growth will spread to the U.S. Very clearly, Europe and Asia are not doing as well as the U.S. in terms of economic growth.

A secondary but substantial issue is that the market is beginning to conclude that QE3 will end in October. The combination of the two was enough to cause some slight selling in the equity markets. It is important for an investor to remember that the market, like trees, does not grow to the sky. A major reason the market can generate annualized returns of 6% above the treasury bill yield is precisely because of the volatility.

Ultimately though, the fear of an economic slowdown is overblown. As a result, the recent selling in the market is an opportunity to increase equity exposure.

Here's why:Global weakness in GDP growth will likely keep interest rates low. If the U.S. economy continues to expand, the combination of a low interest rate environment with growing corporate earnings will push stocks higher over the next twelve months.

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The market's rally on Wednesday, which was sandwiched between extensive selling on Tuesday and Thursday, was driven by the Federal Reserve's remarks that indicated some concern among their board of governors regarding global GDP growth.

This concern prompted the market to buy equities because it indicated that there might be a delay in the coming rate hikes. I think this hope for delay is unfounded. I continue to believe that the Federal Reserve will end QE3 in October.

Yes, there is a small portion of investors who still expect a delay. But the selling we have seen in the market this past week can be partly attributed to a change in course by investors who had been expecting a QE3 extension. They are coming to the realization that the punch bowl of low interest rates is going to be taken away.

QE3 Is Ending Because the Economy Is Growing   

Historical analysis shows that equities generally sell-off immediately following a rate hike but perform moderately well in the months following the rate hike. While the end of QE3 is by no means a rate hike, most likely the market will respond in a similar manner as it is the end of an activity that puts downward pressure on interest rates.

As a result of the end of QE3, fixed-income instruments should begin to come under some pressure and equities should begin to relatively outperform. What we are seeing this year with bonds outperforming stocks is the last hurrah of the three-decade-old bull market in bonds.

With the ten-year treasury yield at 2.3% (down from 3.0% at the beginning of the year), it is clear that the concern about global weakness is putting downward pressure on interest rates. Effectively, the long awaited bond sell-off seems to have been delayed by the phantom of a global recession. The result is a growing concern that the economic recovery is faltering. This belief is misplaced.

The economy is not heading into a recession. Therefore, the weakness in the equity market presents a buying opportunity.

Here Is Why the Economy Is Not Heading for a Recession:   
1. GDP in the second quarter was relatively strong.  Due to lower than expected GDP growth in the first quarter from bad weather, a sharp slowing in inventory accumulation, and an anomalous drop in net exports, GDP growth in the second quarter rose to 4.2%. Economies do not fall into a recession on accelerating GDP growth, the momentum very clearly is for the recovery to continue.

2. Bank lending is becoming looser.  Balance sheets for both corporations and individuals are improving. Lower ten-year interest rates are pushing mortgage rates down which should spur home building. Lower interest rates also mean higher corporate earnings as corporate debt payments go lower.

3. Most likely we are going to see the GDP grow.  We project gains of 3.2% over 2015 and 2.8% over 2016. However, interest rates due to global GDP weakness should remain somewhat under pressure. The combination will be a positive for U.S. domestic equities.

4. Currently, the yield on U.S. 10-year bonds is the lowest it has been since 1949.  If you look at the historical data you come to two conclusions: First, low-yield environments are followed by gradual changes to a high-yield environment and vice-versa. Thus, my best estimate is that rates will remain low for longer than investors expect, but over the next ten years interest rates will gradually trend upward. As a result, stocks should outperform bonds over the next few years.

5. Falling oil prices should cause gas prices to decrease.  This should help retailers as middle-income Americans will increase consumption due to lower gas prices. With the U.S. becoming a net exporter of oil, the geopolitical effects of strife in the Middle East are lessened. Essentially, low oil prices may be a symptom of a slowing global economy but it also provides the basis for an acceleration of GDP growth. Ultimately, lower than expected oil prices is good news for the economy.

6. On balance, the labor market continues to show improvement.  There were 248,000 jobs created last month in September. The consensus estimate was for only 212,000 jobs. Additionally, unemployment is falling. As I have indicated previously, a strengthening labor market should result in rising wages and inflation, but the global weakness is preventing interest rates from rising. Meanwhile, the jobs number suggests further gradual declines in the unemployment rate and solid income gains that would support GDP growth near 3% over the remainder of 2014.

7. Inflation is likely expected to trend higher.  We expect it to rise to 1.6% in 2014, 1.9% in 2015, and 2.0% which is the Fed's target in 2016. We continue to expect the first Fed rate hike in June of 2015, with QE3 winding down in October. There would not be an uptick in inflation if the economy was headed into recession.

8. Household balance sheets continue to improve.  They are aided by a decline in debt relative to income. Also, there have been large gains in household net worth supported by rising equities and increases in house prices. The increase in wealth should translate into higher consumption and less risk-aversion.

Today's Buying Opportunity   

As the economy is not heading into a recession, the current weakness in the stock market presents a buying opportunity for investors. If we project out three to five years from now, interest rates are most likely going to be higher than they are currently and the economy is going to be larger with projected growth of around 3% per year.

However, since we are near 60-year lows on interest rates, my expectation is for interest rates to not increase that dramatically. As a result, equities should continue to perform well over the next few years.

I continue to see the market heading higher from its current level into the last quarter of 2014. Yes, October has traditionally been a weak month for equities, and although I do not put much faith in calendar anomalies, we certainly were overdue for a bit of selling. Once investors finish digesting the end of QE3 and see that the economic expansion is on track the market should begin to trend higher

Would you like to take advantage of growth opportunities in this market within a framework of wealth preservation? Our Zacks Investment management team would be happy to share our strategies with you.

-Mitch

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