Happy Cinco de May to everyone. In honor of the celebration, we elected to highlight trends in the market including the real key to stock market growth.

Economic growth is not exactly a confidence builder.

The recent economic news is anything but pretty. Last week, the U.S. Commerce Department reported a preliminary estimate for first quarter 2014 GDP performance and the figures, if accurate, reflect  the smallest quarterly gain in three years. Although no one was anticipating a bang-up quarter due to the poor weather in the eastern half of the country during the period, the 0.1% gain barely registers any growth at all.

Moreover, big gains for the period such as in consumer spending are masked by the higher fees paid to utilities so the actual numbers might be even poorer.  When one lifts up the hood the picture appears really ugly with business equipment spending and government spending declining , along with home construction.

Against this backdrop, economists are now forced to reduce the GDP growth for the year which may have an impact on the quantitative easing strategy employed by the Federal  Reserve. On the plus side, despite the announced $10 billion drop in bond buying by the Fed, stocks staged a mild rally on the news for the first time in months. Still...

...even good news doesn't help.

Yes, the unemployment rate is now 6.3%, a 5 year low. But you and other investors can see right through this scam number now. With 92 million out of work, and the workforce participation rate steadily declining, the sleight of hand didn’t help stocks and may be an impediment going forward.

A Tale of Two Markets

The dramatic shift in stocks the past six weeks or so has highlighted a serious dichotomy in equities: “The Haves” and “Have Nots” and the spread between the two is likely to widen rather than narrow.  If you wish to be on the right side of the aisle, you should probably first recognize the current trends.

The “Haves” are represented by the 30 components of the Dow which closed at a record at one point last week. Interestingly, this event coincided with the Federal Reserve indicating its plans to cut back on its quantitative easing program by reducing the bond buying by $10 billion to $45 billion, beginning in May, as we mentioned above.  For bulls, this is potentially a decent sign for blue chips as it could help reduce some volatility.  

The notable “Have Nots” are former NASDAQ darlings Twitter (NASDAQ – TWTR) and LinkedIn (NASDAQ – LNKD), which are both down 40-50% from their year highs achieved just a few short weeks ago.  Even with the drops, both stocks are trading at nosebleed levels based on next year’s P/E. LinkedIn trades 55x Wall Street 2015 forecasts while Twitter’s P/E is actually above 155, which is ironically greater than the 140 characters one can use in a single tweet. (Perhaps when it drops below 140 some will think it is a bargain…)

Other “Have Nots” that seem to have fallen under the radar include the micro cap segments.  Volumes are down in the micro cap sector by around 50% as investors have been paralyzed and spooked by the recent volatility. This precipitous drop has prompted market makers to widen spreads which exacerbates the problem further. In the absence of higher volume where they can make money, the market makers raise offers on buys and lower them on sells to make up for the reduced activity. As a result, it is not uncommon to see a stock trade up or down 10% or light activity.

Going forward, the blue chip “Haves” are likely to continue their upward path given their solid EPS growth and reasonable valuations. Conversely, the NASDAQ losers that still trade at ridiculous premiums will probably not see accumulation  until valuations change.  As volume slowly creeps higher on underfollowed micro caps, accumulation and higher prices are more likely to return a lot sooner in this segment than with the more well-known NASDAQ names.

The Trigger...

...will be housing. It has to get better for the market to move higher.

With so much of our economy dependent upon housing and construction, these segments must see real growth in order for the shaken stock market players to regain their mojo and become more engaged.  Unfortunately, housing stocks and mortgage applications figures have been terrible, partly due to the poor Q1 weather as well as higher interest rates.

For the bears, the weak GDP combined with declining, new mortgage applications spells more trouble for stocks and a confirmation that the current market valuation is too high and will decline by 10% or more from current levels.  For the bulls, the fact that first quarter earnings thus far are not terrible and that the signs for the second quarter appear promising bode well for equities going forward, thus confirming that valuations are reasonable.

For me, I believe that valuations are indeed a bit high and while a better second quarter will help stocks bounce back, we may not really see a prolonged rise in stocks again until after the mid-term elections in the fall, unless we see consecutive, monthly growth in the housing and mortgage segments.

Have a great week!