How negative sentiment trumped solid market fundamentals

From

Russell Investments’ Chief Investment officer – Client Investment Strategies Erik Ristuben provides Russell’s views on how negative sentiment trumped solid fundamentals in the market earlier this week.

Could the market be its own worst enemy?
No doubt about it, negative sentiment trumped solid fundamentals in the market on Monday. As the Russell 2000® Index lost 63 points, or nearly nine percent of its value, and the Dow shed more than 630 points (approximately 5.5 percent), it was clear that general concerns about the economic growth rate only exacerbated the blow absorbed on Friday when S&P downgraded U.S. Treasury debt.

When high trading volumes combine with volatility spikes, it’s clear that sentiment is ruling the market, and on Monday that’s exactly what we saw, as 2.5 billion shares were traded on the New York Stock Exchange – an incredibly high volume – and the VIX , Wall Street’s key measure of volatility, topped 46. The good news is that despite the downgrade, it’s not particularly surprising that U.S. Treasuries are considered a relatively safe investment, which shows that investors are not subscribing to the notion that the U.S. is no longer credit worthy.

On the other hand, in sentiment-led markets like we saw Monday, it is possible for the market to effectively talk itself into a recession, and this fear is one of the largest threats to Russell’s current economic outlook, which calls for growth in the latter half of the year. To paraphrase President Franklin D. Roosevelt, “one of the things we have to fear is fear itself.”

Outlook is sound, but ride will be scary
Russell continues to expect equity markets to recover from current levels, an expectation that is based on strong fundamentals, and a view that the U.S. economy will grow 2.5 percent in the second half of the year. The balance sheets of operating companies remain extraordinarily strong, and profits haven’t just been good – they’ve been great, as evidenced by 18% growth in second quarter earnings in the S&P 500.

These companies have been able to accomplish all of this despite relatively low economic growth rates, and some of the headwinds that created the economic soft patch, namely the Japan supply chain disruption and higher commodity prices, are starting to lose steam. All of this means the outlook continues to be solid, and the events of Aug. 8 have all the hallmarks of being a very intense growth-scare market sell-off rather than an indicator of a double-dip recession.

From a consumer perspective, there are some opposing forces playing out. As a positive for consumer spending, consumers generally have more money in their pockets right now due to an increase in real income and a drop in commodities prices, but investment accounts have also taken a beating in the last week, so loss of wealth can be a negative factor. It remains to be seen which factor will determine consumer spending in the second half of 2011.

The good news is that dire predictions that the markets would interpret the downgrade as equating to U.S. bonds’ loss of value has not materialised to date. While a sentiment-driven recession is a possibility, we continue to believe that growth in the second half is a more likely scenario.

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