Federal Reserve Supports Marietta's Positive Outlook for U.S. Economy and Stock Market

On March 21, the Federal Reserve Open Market Committee reiterated its positive year-end forecast for U.S. economic growth in 2014 and 2015. In a subsequent press conference, Fed Chair Janet Yellen stated that weak U.S. economic data in January and February was due primarily to bad weather and would pick up in coming months. She emphasized that "the Committee's views are largely unchanged" since December and confirmed the Fed's prior prediction of 2.8-3.0% GDP growth and 1.5-1.6% inflation in 2014. With this promising outlook, the Fed expects to continue its tapering policy to completion in September. It will proceed to raise its base short-term interest rate after a pause if inflation and employment data continue favorably.

Marietta's January 3 Outlook emphasized the importance of economic acceleration and corporate profit growth in extending the 5-year bull market through 2014. The 29.6% surge in the S&P 500 index in 2013 was driven in part by a 10.8% increase in S&P 500 corporate earnings but even more by an increase in the market's P/E valuation. This "multiple expansion" has resulted in a rise in the Index's current P/E ratio on trailing 12-month earnings to 16.5, which is above the last 10-year average of 14.7 We consider the market to be fully valued rather than overvalued, but we think a further advance should be fueled by earnings growth rather than multiple expansion. Hence, our bullish view relies on our favorable 2014 forecast of 3.0% GDP growth and a rise of 7-9% in corporate earnings.

We are encouraged by the 4th quarter corporate earnings reports released during the 1st quarter. According to Howard Silverblatt at Standard & Poor's, 64% of S&P 500 companies reported earnings above Wall Street estimates and an additional 11% met expectations. He also indicates that company research analysts are currently estimating an increase of 12.1% in aggregate operating profits for all of 2014. Assuming the S&P 500's P/E valuation remains constant through 2014, this increase in profits would reward investors with another year of double-digit returns. We think this scenario is reasonable because the market's valuation multiple is unlikely to contract as long as the expected return on money-market funds and bond alternatives remain unattractive.

A concern for some investors is that the Fed's statement is actually negative for the stock market because it hastens the date of an increase in historically low 0-0.25% short-term interest rates. We are not persuaded. The Fed has clearly indicated that it will not raise rates until it is convinced that economic growth has achieved healthy, sustainable growth, which in turn will increase investor confidence in further profit growth. Our view is that investors will not become excessively alarmed as long as inflation and interest rates remain below long-term norms of 2% and 4% respectively.

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.