An Alternative Risk to Respect

It was a busy week of earnings reporting last week with 12 Dow components and approximately 20% of S&P 500 companies reporting results for the June quarter.

Taking it all in, we were left with one conclusion: the U.S. economy is NOT headed for a double-dip recession. Heck, at times, one was left to wonder if we are even headed for a dip at all.

Incoming economic data suggest of course that we will see a deceleration in GDP growth; furthermore, the Fed Chairman himself acknowledged that likelihood in his monetary policy report to Congress (more on this in a bit).

Thus far, second quarter operating earnings are tracking to be up 34% year-over-year while revenues are on pace to increase 10%, according to Thomson Reuters. Prior to Alcoa's (AA) report on July 12, those growth estimates were 27% and 9%, respectively.

Entering the week, we were resigned to the idea of using interim signs of strength to reduce exposure to cyclical sectors. Exiting the week, we are resigned to putting an end to that strategy.

In fact, with a deliberate eye at this point, we would be overweighting the technology sector, which has demonstrated in the early part of the reporting period that enterprise spending is quite strong and expected to remain so.

The technology sector has also demonstrated that it is loaded with cash that can, should, and will be deployed to boost shareholder returns. Apple (AAPL), Microsoft (MSFT), Cisco (CSCO) and Intel (INTC) alone have over $110 bln in cash and short-term securities on their balance sheets. That is slightly higher than the annual GDP of Iceland, Cyprus, Estonia and Latvia combined. More to the investment point, though, it is roughly $110 bln that is earning close to nothing after inflation.

Remarkably, the technology sector's forward four quarter P/E multiple of 12.6x is a 28% discount to its 5-year average. A price-to-earnings growth ratio of 0.9, meanwhile, also speaks to the value-based appeal of the sector.

PEG ratios, though, are only as compelling as the market's conviction in the achievability of the earnings growth estimates. With this in mind, it can be said the market remains a doubting Thomas on the technology sector's growth prospects.

Those doubts are understandable given the befuddling macro backdrop.

Still, with all of that cash at its disposal and healthy earnings growth potential, the technology sector has GARP appeal. That is, it presents growth at a reasonable price.

Playing Defense Too

There is a fine line that still needs to be walked when putting money to work in the stock market. That seems to be the primary message anyway from the Treasury market where the yield on the 2-year note hit a record-low 0.55% in the past week and the yield on the 10-year note dipped as low as 2.85%.

The aforementioned moves came amid the rush of better-than-expected earnings reports and reassuring guidance. They also came amid Federal Reserve Chairman Bernanke telling the Senate Banking Committee that the economic recovery remains "unusually uncertain."

Briefly, much of what the Fed Chairman conveyed in his monetary policy report was already communicated in the minutes from the June 22-23 FOMC meeting in the prior week. However, the stark reality of hearing the Fed Chairman himself present such a perplexed view was not exactly a confidence builder.

It is unsettling, too, to think that six months ago the Fed Chairman was being asked to explain what the Fed can do to shrink the money supply and contain inflation, whereas today the conversation has shifted to inquire as to what more the Fed can do to support the recovery.

These are uncertain times. Accordingly, we feel money managers should maintain ample exposure to defensive-oriented sectors like consumer staples, utilities, telecom services and health care that have lower betas and/or higher dividend yields.

Furthermore, we would favor the "growth" companies within those sectors, and all other sectors, over the value names at this juncture.

On the defensive side of things, we particularly like the S&P 500 utilities sector, which has a current dividend yield of 4.56%.

The utilities sector is not without its own problems. Regulatory risk is there with the specter of climate change legislation, and business activity has slipped along with the economy, making it challenging to increase revenue.  Still, with interest rates expected to remain low and dividend payouts largely secure, the sector provides an attractive offset for income seekers and should act as a nice shock absorber for equity portfolios in adverse market environments.

To the latter point, the S&P 500 Utilities sector is up 0.7% on a total return basis since April 25 versus a 9.0% decline for the S&P 500.

Caution Has Been Better Part of Valor

Much has been talked about with respect to the downside risks for the stock market.

That is only natural given the 17% slide that was witnessed between the high on April 26 and the low on July 1 and the macro factors -- Europe's sovereign debt problems, China's efforts to slow its growth, ongoing weakness in the U.S. labor market -- that precipitated that slide.

We, too, have had a more cautious-sounding tone in our market commentary, which is why we would like to take some time this week to discuss the alternative risk of a major move to the upside.

Right now market participants seem either scared, confused, disinterested, or all of the above.

Our conclusion here rests on the understanding that trading volume across U.S. exchanges has been relatively weak and that new money continues to pour into bond and income funds, as the return of capital continues to take precedence over the pursuit of a return on capital.

The cautious disposition can be defended given the large uncertainties that are out there. What does it say, though, that participants are not in any hurry to buy into the S&P 500, where the current forward four quarter earnings yield is 8.0%, yet appear enamored with buying a 10-year note yielding 2.90%?

That is a significant equity risk premium, which we said a few weeks ago is either a gift from the value gods or a bedeviling indication that earnings growth estimates are going to need to be marked down considerably.

Before examining some of the catalysts that could trigger a major upside move, we need to stop to consider why that move has not occurred.

In other words, why has the stock market gone from flying high to being grounded?

Cracking Open a Six-Pack

We would assign six primary reasons for why the stock market has been grounded of late.

1) The easy money has been made

Between the intraday low on March 6, 2009, and the intraday high on April 26, 2010, the S&P 500 increased 83%. It climbed a wall of worry that entire time. Now, comparisons are becoming more challenging, and clearly, there is evidence that developed economies still need the support of extraordinary monetary and fiscal policies.

2) The legacy effect

The fallout from the financial crisis of late-2008, early-2009 left some deep psychological scars for money managers and individual investors.

To be sure, the market crash created a newfound appreciation for systemic risk. That is why big, scary thoughts like a domino effect of sovereign debt defaults in Europe, or an asset bubble popping in China, or the U.S. falling back into recession, have killed the momentum of the recovery trade and have resuscitated the risk aversion trade.

It does not matter right now that these may be overblown concerns. The perception that they could easily present a systemic risk is enough alone to keep investors at bay.

No one wants to fall victim again to being ill-prepared for a systemic risk undercutting the market and their investment portfolio. Hence, the return of capital, as opposed to a return on capital, continues to be a primary investment mandate.

3) Impending deflation

Who could imagine with the expansion of the Fed's balance sheet and banks sitting on over $1 tln in excess reserves that the fear of deflation would resonate more today than the fear of inflation?

Alas, that seems to be the case. Even the FOMC is discussing the risk of deflation.

The ongoing decline in Treasury yields, though, has been the most poignant sign that the market respects the potential of a deflationary environment. Again, that may not happen, but recognizing the Treasury market had a better sense than the stock market in predicting the Great Recession, the sharp drop in Treasury yields has had a Taser-like effect on the stock market.

4) A deficit day of reckoning awaits the U.S.

A number of European countries have had their feet held to the fire by bond vigilantes for poor fiscal management.

The situation got so bad that it necessitated a 110 bln euro bailout plan for Greece and the creation of a separate 1 tln euro backstop facility from the EU and IMF that is aimed at preventing a default on sovereign debt in Europe.

This fiscal imbroglio in Europe precipitated a massive flight-to-safety in the U.S. Treasury market.

The latter move notwithstanding, there is an undercurrent of concern that the U.S. could be on a path toward a day of reckoning with bond vigilantes, too, if it does not get its deficit (now 9.3% of nominal GDP) under control soon.

Such an attack on the U.S. Treasury market would have profound implications for global markets as a force-fed, higher cost of financing for the U.S. government, U.S. businesses, and U.S. consumers would pique concerns about the U.S. economy slipping back into recession.

5) Regulatory uncertainty

The Dodd-Frank Bill has been signed into law, yet the big banks are calling attention to the potential for unintended consequences (i.e., bad things) resulting from the bill. While the big banks were reluctant to quantify how the new regulations would impact their income statement, a recurring theme in the earnings reports was that regulatory uncertainty is making it difficult for them to do business.

Regulatory uncertainty has not been confined to the financial sector either.

The health care sector is confronting it with the overhaul of the health care system; the utilities sector is confronting it with the specter of climate change legislation; and the energy sector is confronting it with new regulations certain to arise from the BP oil spill.

While the implementation of new regulations could take some time to flow through income statements, there is continuing concern that the cost of doing business in the U.S. is destined to go even higher as politicians look to increase tax revenue and to reduce the taxpayer's exposure to risk.

6) The tax man cometh

Unless Congress works to change things, the Bush tax cuts will expire for all income classes on Jan. 1, 2011. In turn, the long-term capital gains tax rate will increase from 15% to 20% while taxes on dividends will be assessed at one's ordinary income tax rate.

There is increasing chatter that Congress will work to keep the Bush tax cuts in effect for the lower income classes, but that higher tax rates are inevitable for households earning in excess of $250,000.

The effect higher taxes will have on both the stock market and consumption in the U.S. has been a contributing factor to the concerns about the U.S. economy slipping back into recession.

Caught in the Echo Chamber

With the exposition above, it is no surprise that the possibility of a melt up in the stock market is drawing scant attention.

Again, that fits with human nature, which is strongly predisposed to getting trapped in the echo chamber. That chamber is filling up with plenty of negative thoughts at the moment as economic data have been validating the slowdown argument.

For a forward-looking market that is always looking at trends, though, it is easy to fall on the slippery deduction slope that a slowdown will then lead to a recession.

As noted above, we do not expect the U.S. economy to fall back into recession. Likewise, we also acknowledged above that we have been more cautious about the outlook given the many unresolved macro issues.

We respect the idea, however, that the market often operates in a way that catches the majority of participants by surprise. With that in mind, it behooves us to contemplate what the biggest surprise would be right now.

Our sense is that the biggest concern out there is that the U.S. stock market is poised to suffer another large decline.

That is why the participation factor has been low; that is why the so-called smart money is not buying stocks eagerly despite an 8.0% earnings yield on the S&P 500; and that is why banks are sitting on their excess reserves and why companies are hoarding cash.

The fear is that what happens in the stock market, and the capital markets in general, will dictate what happens in the real economy instead of the other way around.

It seems to us then that the biggest surprise at this juncture would be a melt up in the stock market, not a meltdown.

A melt up is not out of the question at this point either -- not by a long shot (no pun intended).

Fuel for a Buying Fire

What could ignite the stock market again? It is truly anyone's best guess, so here are some of our best guesses.

1) A return of confidence

This is the most obvious statement, so much so that it almost goes without saying -- almost. Confidence is key and it is clearly lacking among institutional and individual investors alike.

There are still many unresolved matters and the inclination now is to look at them with a glass-is-half-empty perspective. That is, Europe is certain to suffer sovereign defaults that will trigger another banking crisis; China is going to experience the popping of an asset bubble; and the U.S. is destined to fall back into recession.

However, what if the sovereign debt issue in Europe does not blow up? What if China manages a soft landing and asset prices there do not implode? What if the U.S., led by a strengthening labor market, continues to grow?

This could all happen, but the fear that none of it will happen is what has brought us to this point.

Renewed confidence that the worst-case scenario(s) will be avoided could be a powerful trigger for the stock market as fear is expunged from the market and relief is priced in.

2) An urge to cash in

There is so much cash out there.

The latest data from FactSet indicates S&P 500 companies have nearly $1.2 tln in cash and short-term securities on their balance sheets. Pressure is building for those companies to enhance shareholder returns by putting that cash to work either through dividend increases, stock buybacks, and/or capital investment.

Separately, the Investment Company Institute reports that there is $2.8 tln in money market funds.

Money market accounts are paying next to nothing and the real rate of return in many instances for cash holders is actually negative. The need to achieve higher returns will kick in at some point, sooner rather than later if confidence in the economic outlook improves.

Then, there is all that cash parked in U.S. Treasuries, content for now to accept 0.60% for the next two years, but obviously willing to chase performance.

An asset allocation shift out of bonds and into stocks that is driven by an improving economic environment, or even a reduction in fear, could be a huge catalyst for stocks.

3) The fear of missing out

There has been a lot of fear and loathing recently and the predominant fear is that the stock market is headed lower.

If that does not prove to be the case and the stock market starts trending higher in the face of bad news, good news, and no news, there is potential for a momentum-based rally that is driven by a new fear -- the fear of missing out.

4) Gridlock in Washington

The midterm elections are less than five months away. A lot can happen in the interim to change the electorate's voting bias. At the moment, however, there is plenty of disenchantment to go around.

A recent Gallup poll reveals there has been a sharp decline in the president's approval rating from roughly 70% in early 2009 to 44% today, which has been matched by an equally sharp increase in his disapproval rating from roughly 20% to 47%.

The upside for the president is that his approval rating looks golden relative to Congress, which is now tagged with a 20% approval rating.

The latter qualifies as one of the lowest on record in a midterm election year, according to Gallup. That rating is up from an abysmal 16% approval rating in March, yet it still leaves plenty of incumbent representatives on the election hot seat.

If history is a guide, there will be a good deal of turnover in Congress. Again, according to Gallup, there has been an average net change in seats of 29 from the president's party to the opposition in midterm election years when Congress' approval rating is below 40%.

For some more recent perspective, Congress' approval rating was 26% at the time of the 2006 election and Republicans lost 30 seats. In 1994, Congress' approval rating was 23% and Democrats lost 53 seats. Both outcomes ended up wresting majority control away from those respective parties.

There has been much hand-wringing about the government's role in the recovery process and, rest assured, there will be plenty of mud-slinging as the campaigning picks up with both parties defending their role in that process.

This is setting up to be a very entertaining election season that should be a boon for advertisers and a potential boon for the stock market if a sense develops that the partisan gridlock of the last two years is going to give way soon to legislative gridlock for the next two years.

5) Feeling cheap

Last week Legg Mason's Bill Miller called large-cap stocks a once-in-a-lifetime buying opportunity, indicating that they are the cheapest versus bonds since 1951.

As noted above, the current forward four quarter earnings yield for the S&P 500 is 8.0%. The current equity risk premium of 472 bps is 95% higher than the monthly average for the last 20 years.

The rub here of course is that the market does not have faith in the achievability of earnings growth estimates, so it has not been seduced by such an attractive-looking earnings yield. The potential lurks, though, for a shift in investment perspective where the market gets past its near-term fixations and sees the significant equity risk premium as an attractive long-term investment calling.

Respect the Risk

There is much to be settled yet with the stock market. Admittedly, we are not entirely comfortable with the outlook.

The continued drop in long-term Treasury rates is disconcerting to us given the robust earnings growth that is being delivered and that is being projected.

According to Thomson Reuters, S&P 500 operating earnings are expected to increase 25%, 32%, 11% and 12%, respectively, over the next four quarters.

Still, there is not a strong enough sense in the market that those growth estimates can be achieved. If there were, we would expect to see the stock market much higher than its current level.

The S&P 500 currently trades at 12.4x forward four quarter earnings, which is below the average forward four quarter P/E ratio of 14.3x over the previous 52 weeks. Applying the average forward four quarter earnings multiple to the current Thomson Reuters consensus earnings estimate of $88.15 computes to a 1260 price level for the S&P 500.

There are a lot of crosscurrents, however, that are restraining investment in the stock market, none more so in our estimation than the feeling amongst money managers that there is a hidden, and negative, reason behind the continued zest for buying Treasuries at such low yields.

At some point, that interest will shift and stocks will be the beneficiary of that buying interest.

We do not know when that shift will occur. Money managers and individual investors, though, need to respect the idea that the bigger risk today is a melt up in stock prices, not a meltdown.

--Patrick J. O'Hare, Briefing.com

Patrick J. O'Hare is the Chief Market Analyst for Briefing Research, Briefing.com's new strategic research service. To request a free trial of Briefing Research, please email researchsales@briefing.com.