The U.S. Economy Contracts! What Now?

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Unless you are a trader that measures holding periods in days, the short answer is nothing.  The S&P 500 has raced out of the gate to start 2013 and is within a stone’s throw of its all-time high.  The bears continue to be proven wrong, but still find their way into popular media outlets to scare everyone. Even the bulls are attempting to “guess” when the next pullback will be given that sentiment has reached excessive exuberance.  This is all noise for investors that aren’t looking to flip their entire portfolio in a year, but instead make investment allocation based on cyclical dynamics that can last anywhere from 18 months to several years.  To these investors, the prudent course is to continue to maintain a maximum equity allocation as the great rotation out of bonds and into stocks approaches.  Equities remain extremely cheap in the context of 1.7% inflation.  Will there be a pullback? ABSOLUTELY.  This is how the markets work.  It can happen at any moment, but looking out 6 months, 12 months, or 18 months it is becoming increasingly likely that equities will be at new highs.  Below are several reasons to maintain a bullish tilt to your portfolio.

Head (line) Fake

Sure GDP contracted by 0.1%, but that was because government defense outlays declined at their fastest rate since 1972.  This appears to be the smaller government that a certain party has been begging for and it came from the industry that the other party demanded.  We should all rejoice, right?  I don’t believe this drop in defense spending is good, but that is a different argument.  The main highlight to the GDP report was the underlying strength everywhere else.  Consumer spending was strong, investment was strong, and housing was exceptional.  Real private nonresidential fixed investment, a proxy for capex surged 8.4% in the fourth quarter.  Anyone looking at the chart below should find solace in the direction of capital spending and what it means for the economy. 


<img src="/media/images/user_36/real-private-nonres-fixed-investment_large.png" />

This supports the continued notion that technology companies such as F5 Networks (NASDAQ: FFIV) will continue to grow as corporations seek out their application software.  F5 Networks is the leading vendor in the application delivery market that provides companies data center flexibility at a fraction of the cost of building out a massive in-house IT department.  The company reported earnings last week and CEO John McAdam echoed a similar tone to the recent GDP report.

                “During the first quarter, strong sales to North American enterprises and service providers were offset by a substantial slowdown in U.S. Federal sales"


Sentiment is Way Too High

TRUE.  Investor sentiment is way too high and will have to revert to the mean via a sideways market or a pullback of some sort.  But this pullback may only be 3%, or 5%, and then it could be off to new highs quickly thereafter.  The chart below shows the American Association of Individual Investors’ confidence and it is at two-year highs.  Notice the peaks since 2009.  There are at least 6 really high readings in the last three years.  Where is the market now?  At new highs!  Do you think you could have timed all six of those perfectly?  Got out and in at the exact right moment?  The bottom line is that sentiment is a worthless indicator for market peaks, but is good at identifying great buying opportunities.


<img src="/media/images/user_36/sentiment_large.png" />

This situation applies to individual equities as well, although in a much greater magnitude.  The classic example right now is Apple (NASDAQ: AAPL), which has seen shares pullback more than 30% from last year’s highs.  How many articles highlighted the attractiveness of the stock as it was soaring to a market capitalization of $650 billion?  A lot.   With a ton of Wall Street coverage, over 85% of the analysts had a buy rating on the stock.  Similar feelings were echoed by the general public as well.  This could be a big factor is the recent pullback of the stock, but is not a reason for long-term holders to exist their position.  In fact, this bullishness by the sell-side was fairly constant as the stock doubled from $350 to $700.  Blindly following high sentiment readings would have prevented investors from owing one of the best performing stocks of the last decade.  Long-term investors should maintain the course on Apple given its competitive position, future growth opportunities, and attractive valuation.

For those looking to capitalize on a stock that has been shunned amid near-term struggles should look to Hospira (NYSE: HSP).  A year ago I recommended investors hold off as the uncertainty was likely to linger.  This was a good decision as the stock has underperformed the S&P 500 by 16%.  The company has since made vast operational improvements as it seeks to please the FDA.  It hasn’t gotten final approval for its key Rocky Mount facility just yet, but hopes to do so in the first quarter of 2013.  Costs related to fixing highly complicated quality control processes have dented near-term earnings, but the company maintains strong competitive advantages as the market leader in generic injectables and the number two player in infusion pumps.  A revisit to 2010 stock price highs would yield investors a return of nearly 75%.

Are We in a Secular Bull?

It is true that the market is due for a pullback given that it has been more than 325 days since a 10% correction.  This is TWICE as long as normal.  However, according to Ned Davis Research advances without a 10% pullback have lasted an average of 330 days WHEN IN A SECULAR BULL MARKET.  Either way, it is likely that the market will encounter a pullback of 10% at some point this year.  The reason to not try and time this is because if we are in a secular bull market then we are only in the fifth inning based on the historical median length of secular bulls.  Unfortunately, it isn’t easy to classify these periods as they are evolving.  Market valuation, demographics, average asset allocation, and several technical indicators all lend to the idea that a secular bull market is underway.

If true, then reducing fixed income allocations in favor of equities makes sense.  Those that favor ETF investing may opt for the mid-cap space via SPDR S&P 400 ETF instead of the blue chips of the Dow Jones Industrial Average.  Mid-caps and small-caps historically outperform large-caps during secular bull markets. 

The Foolish Bottom Line

Don’t be whipsawed by the daily economic indicators; focus on the trends instead.  The economy remains on much firmer ground as housing and business capital expenditures start bouncing off rock-bottom levels.  This trend will likely persist for years with equity markets in a new secular bull market.  Staying the course and not being scared by headlines remains the prudent course of action as the bears slowly capitulate- adding further impetus to the secular bull market.         

market8 owns shares in F5 Networks. The Motley Fool recommends Apple and F5 Networks. The Motley Fool owns shares of Apple and F5 Networks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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