History Gives a Reason to Be Hopeful about U.S. Stocks

Volatility has hamstrung U.S. stocks recently, but history suggests there's a reason for hope on the horizon.

The past week and a half has been a welcome reprieve from the extreme volatility we've seen over the past few months. There have been no fewer than 19 days this year in which up or down volume has accounted for more than 90% of total volume.

The rapid up-and-down, all-or-nothing nature of the stock market has confounded even the most talented, highly paid and well informed traders. The hedge fund industry as a whole has been caught flat-footed - posting losses in each of the last two months.

The average fund lost 1% in June, according to Barclay Hedge. Combined with the 3.2% loss posted in May, the one-time masters of the universe have experienced the worst two-month performance since October-November 2008 - right in the midst of the post-Lehman financial crisis.

With the price action so volatile, one of the most important tools in our arsenal is history. An analysis of historical data can provide a guide into how market participants reacted in the past under similar circumstances.

The 95% down day on Friday, July 16, was curious because stocks had been rallying impressively for two weeks before the big sell-off. Normally, big down volume days come within the context of a short-term downtrend. The same is true for 90% up days, which normally occur during uptrends. This piqued the interest of Jason Goepfert at Sundial Research. He looked at what happened over the last 25 years when there was sharp sell-off that resulted in a 95% down volume day within an uptrend.

The result: There were only 12 other instances and the market did well in the months that followed. In 10 out of 12 times, stocks were higher three months after the event with an average return of 7% overall. But the data also suggests we should prepare for some short-term choppiness: Two weeks out, stocks were only up 8 times out of 12 with an average loss of 1.2%, as you can see in Sundial's table below.

This suggests that large one-day sell-offs within uptrends do not tend to be the initiation of a new downtrend. This thesis is supported by market breadth: The number of stocks moving higher these days continues to outpace the underlying price action, suggesting someone is quietly accumulating shares in anticipation of a move higher.

Historical Perspective

Staying On Guard

We may have history on our side, but we can't escape the fact that earnings are likely to disappoint as the economic growth rate slows.

International Business Machines Corp. (NYSE: IBM) provided the latest example of this. The company reported slightly better-than-expected earnings of $2.61 per share versus the $2.58 consensus estimate but missed on revenue of $23.7 billion versus the $24.2 billion consensus estimate. Profit margins also missed estimates. And forward guidance came in under expectations. As a result, shares were hammered in after-hours trading, down 4%. It was reminiscent of what happened to Intel Corp. (Nasdaq: INTC) and Alcoa Inc. (NYSE: AA) the week before.

Overall, we're likely to see the U.S. stock market chop around current levels. At worst, we could see a slide back towards the 850 to 900 level on the Standard & Poor's 500 Index by mid-autumn before stocks are cheap enough to attract bargain hunters in quantity.

Down then up; up then down. As soon as a trend appears to be getting established, momentum is wiped out and stocks reverse direction. While it's been great for day traders sweating over five-minute bars, it's frustrating for everyone else. Stepping back from the daily cut and thrust, one realizes that stocks haven't actually gone anywhere since last September.

That's 10 months without progress despite record corporate cash generation, earnings growth, ultra-low interest rates, new job creation, massive fiscal and monetary stimulus, and the fact total economic output has moved to record highs. What gives?

It's earnings multiple compression. Investors are less willing to pay for earning growth as risk aversion rises. Instead, people are moving their assets into cash and government bonds. And that's why the two-year yield on U.S. Treasuries has fallen to just 0.6% - a level not seen since 1941 when the Federal Reserve was subsidizing America's fight against Nazi Germany and the Empire of Japan by purchasing government bonds.

That compares with the high of 17% reached in 1981.

All of this serves as a reminder that despite what they teach in business schools, earnings growth, interest rates, and profitability are not the only determinant to stock prices. Sentiment plays a big role. And right now, many long-term investors just don't want to own risky stocks, preferring the safety of bonds.

And that's why your portfolio should have a heavy allocation to bonds and defensive, high-yield stocks... for now, at least.

[Editor's Note: Money Morning Contributing Writer Jon D. Markman has a unique view of both the world economy and the global financial markets. With uncertainty the watchword and volatility the norm in today's markets, low-risk/high-profit investments will be tougher than ever to find.

It will take a seasoned guide to uncover those opportunities.

Markman is that guide.

In the face of what's been the toughest market for investors since the Great Depression, it's time to sweep away the uncertainty and eradicate the worry. That's why investors subscribe to Markman's Strategic Advantage newsletter every week: He can see opportunity when other investors are blinded by worry.

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