Look for a Pause, Not (Bear) Paws

Stock investors are feeling confused of late–and you can't really blame them. The headline stock market indexes (Dow, S&P 500) edged up in mid-May to all-time highs. Yet many of last year's favorites continue to stumble: biotechs, social media, small caps. Perma-bears, sensing an opportunity to salvage their battered reputations, are snarling into TV cameras with spine-chilling predictions of an imminent crash.

Is it Apocalypse Now? I don't think so. Yet it's abundantly clear that some areas of the equity market became way too richly priced at the end of 2013 and into the first quarter of this year. Those stocks–and even whole industry groups–are taking a well-deserved bath, which may continue through most of the summer.

Furthermore, I agree with the bears that the ongoing "correction" in the glamour names will likely dent a broader list of stocks before all is said and done. When Mr. Market gets into a mean streak, he often lashes out indiscriminately, even if many of his targets only suffer a glancing blow.

But a steep marketwide drop (20% or more in the headline indexes) seems improbable. Three reasons why:

  • Interest rates remain low, with credit readily available. On the eve of almost every severe market break, the Federal Reserve tightens credit by jacking up interest rates. Nothing of the kind is happening now. Although the Fed has cut back on its purchases of bonds and mortgages (QE), interbank lending rates are still hovering around 0.25%. With the cost of funds so low, banks' commercial and industrial loans are growing smartly again (10.2% year-over-year), after a slowdown in the second half of 2013. That's a recipe for economic expansion, not recession.
  • CEOs are taking a rosier view of the economy. I actually give more weight to CEOs' thinking than consumers', because it's the former who hire the latter! Before each of the past three recessions, the Conference Board's quarterly survey of CEO confidence logged a sharp, sustained decline. The most recent (Q1) reading shows CEO confidence at a two-year high. Again, not the stuff of which catastrophes are made.
  • Our stocks are doing well! That may seem like a nave observation, but the fact is that market crashes usually occur when investors have been chasing speculative stocks and ignoring the type of merchandise we favor at Profitable Investing (dividend-rich, value-laden issues).

Frankly, the intense speculation on Wall Street last year worried me. Steady dividend payers lagged, while the LinkedIns and Twitters soared. Ah, but now the shoe is on the other foot! Our REITs, utilities and preferred stocks have climbed smartly this year, while the speculative dandruff has fallen to the floor. Could it be that a good part of the long-awaited "correction" has already taken place, right under our noses?

I'm not ruling out the possibility of a deeper pullback for the marquee indexes than we've seen so far. In fact, I expect it. However, I now believe the summer retracement may not take the S&P 500 more than 6%9% below its May peak.