We continue to be bullish on the outlook for US equities over the next 12 to 18 months, but also continue to believe an intermediate market correction is increasingly likely. The only question is how severe it will be.
Our guess is that the damage will likely be contained to the -5% to -10% level, and we believe the proper mindset for investors will be to remain constructive through any correction because the risk/reward ratio becomes increasingly favourable as the market declines.
Our bullish outlook over the next 12 to 18 months is based on the following reasoning: credit markets continue to normalise with credit spreads back to pre-Lehman levels; every meaningful leading economic indicator is pointing to recovery; the recession appears to be ending or over; real GDP growth should be meaningfully positive (+3% to +4%) in the third quarter; corporate
profits are poised to snap back sharply and appear to be continuing to surprise on the upside; inflation remains well contained; and the Fed will likely not begin tightening until the latter half of 2010.
In short, all of the pieces necessary for a constructive backdrop for equities are falling into place.
After its rally since March, the US equity market began to run into weakness in late September with the release of some weaker-than-expected data, which included news from the Institute for Supply Managers that the Chicago Purchasing Managers Index had dropped in August, although investors had expected a rise.
The next day, the Institute for Supply Managers’ monthly index of US manufacturing activity showed a drop for September, again disappointing consensus expectations of a rise.
Slightly higher-than-expected initial unemployment claims, also released on October 1, exacerbated investor concern.
We firmly believe, however, that the overall weight of the evidence continues to suggest that the economy has begun to recover.
Even modest nominal GDP growth of 5% over the next year, a well below-average recovery rate by historic standards, will likely produce corporate profit growth of three to four times that rate because corporate America is so “lean and mean,” having cut payroll, inventories and overhead costs so aggressively.
If profits recover sharply, as we expect, stock prices will ultimately follow. With the market up so strongly since March, a correction at some point is to be expected. But as noted above, we believe the best course of action will be for investors to get more bullish, not less, as the market pulls back.
David Nelson is chairman, Investment Policy Committee, Legg Mason Capital Management
