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VOL. 127 | NO. 76 | Wednesday, April 18, 2012

David Waddell

Steering Through Muddied Waters

By David Waddell

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The Flows Knows While rationality has returned to the markets, occasional bouts of volatility (as we have experienced over the last few trading days) can muddy the analytical waters. After a 30 percent advance in the S&P 500 from the October lows, a pullback seems appropriate, and the reaction to the recent pullback couldn’t be more telling.

Retail investors express selling urges while institutional investors express buying urges. Remember that rational markets do not peak until retail investors feel compelled to “buy the dips.” At the moment, the dip buyers are institutional types. Institutional investors operate less from feel and more from relative valuation comparisons and their incremental money has been flowing into stocks. Retail investors operate with a lag, so before they begin over-allocating to equities, they have to under-allocate to bonds.

Based upon mutual fund flows data, not only have retail buyers shunned stocks, they continue to gorge on bonds. Even with the S&P 500 a mere 11 percent below its all-time highs, retail investors are still sellers, not buyers.

With bond market returns sputtering as the economy firms, household bond sellers may become stock buyers. This retail shift would indicate that the later stage of this bull market has commenced and will provide the propulsion to challenge record highs.

Taking it from the Top For the fourth quarter only .2 percent of the 8 percent profit gain in S&P 500 companies came from improving profit margins. The remainder was all revenue related. Changes in global growth or inflation assumptions now directly influence earnings assumptions and stock performance. The IMF projects real-world GDP will grow 3.5 percent or so in 2012. With global inflation running 2-3 percent, the corporate revenue and profit environment implies growth of about 6 percent.

If we separate the world into geographic regions, expectations are for the U.S. to grow organically as the unemployment rate falls, for Asia to offset export weakness with local demand strength, and for Europe to shrink but survive.

Thankfully, the world central banks provide an insurance policy. If U.S. employment gains stall, the Federal Reserve will print. If the Asian miracle fades, China will cut rates. If the European financial system chokes, the ECB will spew more liquidity.

So the markets are now completely focused on these two macro inputs. Input 1: Economic strength vs. weakness. Input 2: Central Bank willingness vs. reluctance.

While the first input may intuitively appear more meaningful, the market actually responds more to the second. GDP may disappoint. Credit flare-ups in Europe and funky seasonality issues in the U.S. may crimp growth. China’s transition from exporter to importer changes the world’s growth calculus … in a good way, but an unfamiliar way.

So we wouldn’t be surprised if economic softness didn’t caution markets. However, we believe the Global Central Bank “insurance policy” remains in effect, undergirding the economy, earnings and stock prices. Therefore, like our institutional peers, we view sell-offs as buying opportunities. We invite all of you retail bond investors to join us!

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.

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