Fear has taken over the market

I believe we are getting closer to an inflection point that will be triggered by specific events. At this moment, oil and stocks are highly correlated. As a result of this relationship, stocks are completely ignoring company fundamentals and fear has taken over investor psychology. On down days, even airlines (a big beneficiary of lower oil) drop that ignores the fact that oil is the largest cost for the industry.

While we are only about one quarter through the earnings season for small caps, stocks are reacting to macro factors while ignoring company fundamentals. According to Furey Research Partners, the small cap earnings picture is actually better than the consensus estimates. Earnings growth for the Russell 2000 so far is 7.4 percent on 4 percent revenue growth, indicating a slight acceleration quarter over quarter. However, meeting or exceeding earnings estimates and guidance still does not guarantee stock price appreciation. Fear of a global slowdown is the driving force for the recent action in the market.

Here are four things that need to happen in order for us to feel confident that the correction has run its course:

Traders work on the floor of the New York Stock Exchange
Andrew Burton | Getty Images
Traders work on the floor of the New York Stock Exchange

1) Data from China need to stabilize. We don't need to see the data improving but we do need to see signs that they are stabilizing. The uncertainty over the slowdown in China has become the world's economic problem. Currency instability has put upward pressure on the dollar at a time when the Federal Reserveis looking to increase rates. The slowdown has been going on for some time, therefore stability even at lower levels of GDP growth would be well-received by the market. 

2) Oil needs to stabilize — even if it's at the current price in the low $30's. Consumers and many industries are beneficiaries of lower oil prices. Price stability will accomplish two things: 
Companies that use oil will have visibility on their earnings; and
 merger activity will likely pick up among the energy companies as CEO's can evaluate assets.

3) The dollar, which seems to have peaked, needs to go lower. Normally, small caps do well in a stronger dollar environment but as a result of the global currency instability, the strength of the dollar has created headwinds for U.S. exporters. I believe that the dollar will weaken when the Federal Reserve begins to communicate that rate hikes will not happen as quickly as previously thought and the market realizes that the recently passed budget will widen the deficit reversing the trend from the prior four years.

4) Corporate bond spreads over Treasurys need to narrow. Over the last 8 months, spreads have widened considerably, increasing funding costs for many companies issuing debt. High yield issuance has all but stopped. Narrowing corporate bond spreads are an excellent leading indicator, particularly for small-cap stocks.

While the current environment is frustrating to say the least, I do believe that stocks, particularly small-cap stocks, are much more attractively priced today than at any time in recent history. As we get further into the year, spending from the budget passed at the end of 2015 should provide a tail wind to the economy and company earnings. Since sequestration was activated in 2013, the deficit has been coming down, but new spending will reverse that trend with increased spending for defense, infrastructure, medical research, and incentives for capital spending through investment tax credits. A widening deficit tends to be a leading indicator of a weakening dollar.

Commentary by Dennison "Dan" T. Veru, executive vice president and chief investment officer at Palisade Capital Management.

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Disclosure: The information contained herein reflects the view of Palisade Capital Management, L.L.C. and its affiliates (collectively "Palisade") as of the date of publication. These views are subject to change without notice at any time subsequent to the date of issue. All information provided in this commentary is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security.