The Positive Case for U.S. Stocks in 2014

Our assessment of the U.S. economy and stock market conditions leads us to conclude that the 4+ year bull market in stocks, which includes an S&P 500 surge of 25% in 2013 through December 16 and a 160% gain since March 2009, will continue through 2014. We predict an advance of 7-9% in the S&P 500, which would be in-line with a 7-9% jump in corporate profits. A double-digit increase is possible if the “multiple expansion” of 2013 extends into next year. Corrections are a normal characteristic of bull markets, and some believe that the current market is overdue for a 10%+ setback, but we would view such a correction as a buying opportunity unless there is a change in the following favorable economic and market conditions:

• We expect U.S. GDP growth to increase 3% in 2014, which is in line with the Federal Reserve’s forecast and a December 5 Bloomberg survey of economists. This economic growth will likely result in corporate profit growth of 7-9%. Thomson Reuters Baseline reports that the consensus projection is 8%.
• Fundamental to our upbeat economic forecast is low inflation and a continuation of the Federal Reserve’s accommodative policy that includes near zero short term interest rates until at least 2015.
• The market remains fairly valued despite the significant gains in 2013. The current S&P 500 P/E ratio of 16.4% is only slightly above the long-term norm of about 15%.
• A major stock market development in 2013 was that stock prices rose over 20% when corporate profits grew less than 5%. The “multiple expansion” which resulted is characteristic of a maturing bull market and may well extend into 2014. This would raise the 2014 market advance into double-digits.
• Money market funds and bonds remain relatively unattractive. Money market funds yield at or near zero and are likely to remain low due to Fed policy. Bond yields are historically low and Federal Reserve tapering is expected to result in higher bond yields (and lower bond prices).
• Data compiled by Strategas indicates that the 4+ year bull market through this November has resulted in an outflow of $370 billion from stock mutual funds, whereas they report an inflow of $985 billion into bond mutual funds. Improving economic conditions and a rising stock market could convince investors to reverse these flows. A “Great Rotation” could occur in 2014 as investors shift from bonds to stocks.
• Stock markets have a history of climbing a wall of worry. A November 26 Merrill Lynch report on investor sentiment indicates that confidence remains at the same level as at the depths of the bear market in early 2009. Some skeptics argue that the market is now in a bubble condition, which we think untenable when there is such a high level of pessimism.
• Corporate cash balances remain very high. Improving economic conditions may induce corporate managements to increase dividends, stock buybacks, and merger and acquisition activity, all of which are positive for stock prices.

A relevant consideration in our market forecast is that the level of risk in the U.S. market is reduced from prior years. The possibility of a relapse into recession is diminishing as foreign economies expand and geopolitical tensions moderate. Investor concern with dysfunction in Washington has declined significantly over the past two years, with neither political party willing to appear obstructionist as a general election approaches.

We view the upcoming, widely anticipated reduction in the Federal Reserve’s bond buying program (tapering) as a threat to the U.S. market. The fear is that tapering will force rates up to such an extent that it will choke off the housing industry, discourage consumers, and trigger a possible recession in an economy that has yet to restore full health. We think this is unlikely because the Federal Reserve is highly sensitive to declining growth and would adjust its policy if this outcome seems possible.

Despite the fundamental economic and market positives, there is a nagging suspicion held by many investors that something ominous is on the horizon. This view is often based on an awareness that the average duration of past bull markets is about 5 years and the current bull market is approaching this point. Markets do not operate on a preset clock and we encourage investors to base their strategies on empirical conditions. Underlying economic fundamentals are much more reliable predictors of market tops, and they are currently propitious.

U.S. Economic Outlook

            Prospects for the U.S. economy in 2013 are brightening …unless the politicians permit the economy to go over the “fiscal cliff” (the combination of government tax increases and spending cuts scheduled to take effect at the end of the year unless the Congress and the Administration take preventive action).  We do not expect this to happen, and there may well be a significant stock market gain if a political compromise removes the danger.     

            In our last two Outlooks, we highlighted the progress underway in the multiyear restoration of consumer confidence and spending, the housing market, and the banking industry.  We emphasized that each of these three key sectors was crippled during the 2008-09 recession.  From the outset of the recovery, we referred to them as “structural impediments to growth,” which would take years to heal fully despite pro-growth fiscal and monetary policies from Washington.  Our point was that whereas they restrained recovery over the past three years, we now expect each to support growth in 2013. 

            A number of recent reports and developments lead us to conclude that the U.S. economy is already strengthening:

·                Consumer confidence is at a 5-year high.

·                Consumer spending, bolstered by 2 consecutive upbeat employment reports, is resulting in better than expected retail sales. 

·                A retreat in gasoline prices further supports consumer confidence and spending.

·                The housing market has clearly bottomed in response to rising demand, reduced foreclosure pressure, and record low mortgage rates. 

·                Bank profits are up, balance sheets are much stronger, and loans are increasing.

·                The Federal Reserve has stated unambiguously its top-priority is economic growth and has promised to keep interest rates low until recovery is assured, which many expect to be 2014 at the earliest.

·                U.S. exports may well benefit from the continuing initiatives taken by central banks around the world to stimulate growth.  International Strategy and Investment (ISI), a highly respected economics research firm, has counted 296 easing steps by central banks over the past 14 months.

The mostly positive economic news of the past 1 1/2 months supports our above-consensus October 1 forecast of 2.0-2.5% GDP growth in 2013.  This would not qualify as healthy growth, but nevertheless represents an improvement over 2012.                    

Hurricane Sandy has inflicted significant human hardship and misery, and has caused near-term economic disruption.  However, in the long-term we expect the recovery efforts and the resilience of the people and businesses affected by this tragedy to rebuild, thus mitigating the overall economic impact.

The major threat to our generally favorable outlook for continued economic expansion is the “fiscal cliff.”  We continue to think there will be a political compromise because neither party can afford the risk of being blamed for an avoidable recession.  We are encouraged that leaders of both political parties have expressed a willingness to compromise.  Nevertheless, we do not underestimate the impact of partisan politics and recommend that investors maintain vigilance and flexibility.

We encourage our clients to contact us and let us know their views.

Global Stock Markets off to Strong Start in 2012 Led by Emerging Markets

So far this year global stock markets have risen at a rapid pace; extending the rally begun in the fourth quarter of 2011.  Since January 1, the S&P 500 gained 4.5%, a starting year rally not seen since 1987. Over the same time period, the iShares MSCI Emerging Markets Index Fund (EEM) gained 9.1%, the fastest rise since 2001.

Articles in the Financial Times and Bloomberg have noted a pattern in this rally. The biggest decliners last year have led the charge this year. Year to date the EEM, which lost 21.1% in 2011, has gained twice as much as the S&P 500. On a sector basis within the S&P 500, financials, industrials, and materials have been leading the recent rally. These same sectors have greater exposure to emerging markets and were among the worst performers last year. Utilities, health care, and consumer staples had been the best performing sectors in 2011 but have been among the worst performing sectors in 2012.

Economists attribute the surge to a number of reasons:  in the U.S., positive economic data continues to flow, manufacturing is growing, jobless claims are falling, and the unemployment rate is ticking down. Corporate profits remain high and Fed policy continues to be accommodating. Earnings season has begun with 60% of reporting companies beating expectations. Many global central banks are lowering rates in order to promote growth after two years of raising rates. As mentioned in Marietta’s blog Promising News from China, recent events in China indicate that economic stimulus and easing will likely come soon to this engine of global economic growth.

Three weeks do not make a year, but a continuation of current trends could result in 2012 being dramatically different from 2011.

U.S. Stock Market Rally Supported by Economic Data and Corporate Profits

The 11.7% rally of the S&P 500 Index in the 4^th quarter through November 11 is part of a global stock market advance that includes Europe and the emerging economies. Most market observers attribute the gains primarily to developments in Europe, where policy makers have made progress in containing the sovereign debt crisis. Not to be overlooked, however, is the contribution made by encouraging economic data and strong corporate profits in the U.S. and by signs of ebbing inflation in some of the leading emerging countries, especially China.  

U.S. economic reports in October and thus far in November have been surprisingly good, especially in relation to the rising fears in September of an imminent and severe double-dip recession. Last week’s news, for example, reveals that small business optimism ticked up, consumer confidence indices rose, weekly initial unemployment claims continued to fall, mortgage applications rose, the trade gap narrowed, consumer credit expanded, and import prices declined. Despite a faltering Euro-Area economy, the U.S. economy continues to grow, although at an anemic pace.

U.S. corporate profits have also defied pessimists’ forecasts. Over 90% of companies in the S&P 500 have reported earnings so far this quarter, and over 70% have exceeded Wall Street estimates. International Strategy and Investment (ISI), a widely respected research firm for institutional investors, reports that S&P 500 earnings are running 5.8% above projections, and they are expected to be up about 18.3% year over year when the remaining companies report.   

We pointed out in our October 4 Outlook that global stock markets were “very oversold.” At the time, the markets reflected a recession-level collapse in economic growth and corporate profits despite a significantly more positive consensus forecast of economists. We view the market’s recent rally as only a partial adjustment to this oversold condition. During the last year, when S&P 500 profits soared about 18%, the S&P 500 Index rose only 4%. As a result, the P/E ratio of the S&P 500 Index based on consensus 2011 earnings estimates is now 13.1x, which is still below the past recession average of 13.7x. The consensus estimate of a further 7% profit advance in 2012 would further improve the market’s valuation.

Our conclusion is that if the U.S economy continues to avoid recession, as most economists expect, then the U.S market is still oversold.           

U.S. Economy: The Good and The Bad

Investors over the past few weeks have been beset by a strong dose of volatility in both news reports and stock markets. Economists disagree on where the U.S. economy will go from this point forward and their forecasts seem to get increasingly divergent by the day. A recent Bloomberg article, “It’s the Dog Days of Summer, Shall We Take a Double Dip?: The Ticker,” discusses varying views on the likelihood of a double dip recession. The article enlightens both the optimistic and pessimistic sides of the issue. Their conclusion indicates that although the U.S. and global economies are clearly moderating, the consensus scenario is that recession will be avoided.

The Bad:

Polls conducted recently by the Wall Street Journal and USA Today reveal that the consensus on the likelihood of the U.S. entering another recession has risen to 30%, twice as high as a few months ago. Economists generally accept that U.S. growth will be slower and unemployment will remain inflated for a longer period of time than previously thought. On August 22, Citigroup, Goldman Sachs, and JPMorgan Chase cut their 2011 and 2012 GDP projections. Finally, the need to reduce government spending will handcuff legislators from adopting stimulus measures and the Fed has few tools left to jump-start growth.

The Good:

The consensus on the likelihood of entering another recession is still below 50%. Bob Doll, the chief equity analyst at BlackRock, states: “Stocks have fallen 15% or more in the past few weeks, but since the Great Depression there have been 30 market declines of 15% -- but only two of those predicted a recession.” Even with their reduced U.S growth outlook, Citigroup will projects a 20% stock increase over the next 12 months. The jobs picture is discouraging, but is still strong enough to avoid recession. To be sure, the 12-month data regarding new jobless claims has improved and bank lending conditions have eased. Credit flows, an indicator of reinvested savings, continue to be adequate. Corporations are generating strong profits and carry record cash holdings. Recessions are usually associated with having a negative bond yield curve (whose short-term rates rise above long-term rates), and right now the U.S. has the opposite. Schwab economists sum up these positives with the observation that the U.S. will avoid recession “due to continued positive leading economic indicators, an improving jobs picture, solid corporate balance sheets and a still-steep yield curve.”

The slowing U.S. economy is expected to have only a limited impact on global growth. For example, Morgan Stanley recently cut global estimated GDP growth in 2011 to 3.9 percent from 4.2. The dramatic fall of world stock markets in the past few weeks, which we consider excessive, discounts a much greater than 0.3 percent drop in global growth. For a more in-depth view of Marietta’s opinions on this issue, please refer to earlier posted blogs “Clouds Gathering on the U.S. and International Economic Horizon” and “Financial Market Turmoil.”