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The first half of 2013 was good to investors in the S&P 500 (SPY), but the game has changed. Investors were fearful coming into the year. They feared uncertainty, rising taxes, the fiscal cliff and more. Now the prevailing sentiment is hope. Hope that the Fed and the bond market are on the same page. Hope that earnings will deliver. There are reasons to be hopeful, but it is much more difficult to invest in an environment of hope than an environment of fear. In this article, I will discuss the four main dynamics impacting the S&P 500 for the rest of the year. Each of these dynamics could be a positive or negative catalyst for the market. I am cautious in the short/medium term, but ready to change my view depending on how these dynamics play out.

Central Bankers

Central bank policies were a tailwind for the S&P 500 at the beginning of the year. Now they are a headwind.

The US Federal Reserve launched QE Infinity in December 2012 and effectively ended it over the last few weeks. The Fed is still buying $85 billion of bonds per month and will likely continue buying bonds into 2014. However, the Fed's comments on tapering, which began around May 9 with a Wall Street Journal article (article appeared on May 11, but rumors about it surfaced a couple of days earlier), reversed much of the positive benefits of the bond buying as the tapering discussion caused a bond sell-off that drove yields higher (the opposite of the intended effect of QE). Bond yields have shot up since mid-May and the S&P 500 broke its multi-month uptrend amid increased volatility. The Fed sent a clear message that the S&P 500 was enjoying the benefits of QE Infinity too much and needed a pause. For more about this, please see: Correlation Between S&P 500 And Fed's Balance Sheet Threatened By Rising Rates.

The recent actions of the People's Bank of China [PBOC] took many market participants by surprise. Investors had grown accustomed to the PBOC easing when China faced problems. Earlier this month, the Shanghi Interbank Offer Rate (SHIBOR), the Chinese equivalent of LIBOR, spiked and the PBOC, surprisingly, did not immediately come to the rescue. Later, the PBOC said the right things about providing liquidity and stabilizing the situation. However, the initial spike sent a message to Chinese banks that the good old days of reckless credit practices are coming to an end.

The SHIBOR incident is not a Lehman-like event. The real impact, however, will be felt over time.

The Chinese economy has benefited from reckless credit expansion. The PBOC's message may cause banks to pull back on lending. Tighter lending means companies will have a harder time accessing capital for growth. I expect the PBOC and the Chinese government to continue to take steps that moderate the growth rate.

At the beginning of the year, Europe was still recovering from the crisis of last summer and European assets were still rallying on the back of the Draghi Put. However, the European Central Bank [ECB] has not followed up with a European style quantitative easing program. It lowered interest rates, but the impact is minimal.

Mario Draghi and other ECB officials repeatedly stated that there is a limit to what the central bank can do to help the economy and the real action needs to come from politicians. I still expect the ECB to do something, but it is hard to say that the ECB is a positive for equity markets at this point.

Finally, there is Japan. The Bank of Japan unleashed a massive quantitative easing program a few months ago that has been a driver of big gains in Japanese equities. The Japanese QE program is moving ahead, but the capital markets have paused. There are many skeptics on Japan and it will take more time to determine if the Bank of Japan can continue to drive up equities in Japan and if the added Japanese liquidity benefits investors around the globe.

Earnings

At the end of the day, fundamentals drive the S&P 500. My last update on S&P 500 earnings can be found here: S&P 500's Fundamentals: Update On Earnings, Valuation And Estimates (I plan on updating it soon).

The earnings picture for much of 2012 was not pretty. Earnings growth decelerated and the top line was especially weak. Time after time, news headlines flashed, "Company missed revenue expectations, but EPS in-line."

My takeaway from Q1 2013 earnings season was that earnings were good, but not great. Expectations were low considering the previous few quarters and the dynamics in Q1 (tax hikes, sequester, etc.). The S&P 500 seemed to show some earnings growth and, at least, gave reasons to believe that results would be better later in the year. Investors reacted well and the S&P 500 continued to rally through earnings season.

The bar is much higher for Q2 earnings. Now that the Fed crashed the momentum, only earnings are supporting the S&P 500 at these levels. It is hard to see upside for the S&P 500 if Q2 earnings are again "good, but not great."

Inflation

Inflation, apparently, fell off a cliff. The latest set of economic projections from the Federal Reserve include much lower inflation forecasts. Commodities are falling across the board. And the Treasury Inflation Protected Securities (TIP) market has been crushed as investors no longer fear inflation and chase negative yields.

It seems like inflation can only bring more bad news.

Low inflation has been cited by some as a reason for the Fed to continue with QE Infinity. James Bullard famously dissented from the last FOMC decision because he feared that inflation was too low. He wanted the Fed to be more aggressive (meaning more QE and not taper) to combat low inflation.

However, the tapering consensus will grow stronger if inflation picks up in the next few months. Equity investors will not like that.

If inflation remains low, or declines further, we will have a bigger problem for equity investors, especially over the long term. A modest degree of inflation allows companies to raise prices. If managed properly, the inflation can also boost earnings.

In fact, a lot of the earnings growth of the S&P 500 is attributable to inflation.

In 1988, the S&P 500 generated $24.12 per share of operating earnings. In 2012, the S&P 500's operating earnings grew to $96.82 per share, representing a $72.70 increase.

According to the Bureau of Labor Statistics inflation calculator, $24.12 in 1988 is equivalent to $47.49 in today's buying power.

This means that of the $72.70 increase in S&P 500 earnings since 1988, $23.37 came from inflation. That's 32%!

I know that this analysis may not be fair, since the companies in the S&P 500 today are not the same as in 1988. The larger point, however, is harder to refute. Inflation is an important driver of earnings growth over the long term.

Furthermore, earnings growth is an important driver of multiple expansion. If we are expecting very low inflation over the next few years, then the arguments for multiple expansion are challenged.

Multiple

The S&P 500 is currently trading at ~16.5x LTM operating earnings. In my previous article about the S&P 500's fundamentals, I showed charts of the S&P 500's P/E multiple going back to 1988. The current multiple is at the high end of the range for the last 3 years, but still very low compared to the last 25 years.

At this level, the S&P 500 isn't cheap or expensive. Usually the valuation pendulum swings too far in one direction, but right now it is sitting in the middle.

The S&P 500's multiple is not a catalyst right now. It seems wrong to use valuation as the main driver of a short/medium-term outlook for the S&P 500. The S&P 500's multiple could trade up or down by a couple of turns and still not be stretched.

Conclusions

The game has changed. Central bankers were a big driver for the S&P 500 in the first part of the year. They are now somewhere between neutral to a drag.

In their place, earnings are going to be more important. Q1 earnings got the job done. The bar seems higher for Q2 earnings, and they need to improve to drive the S&P 500 to new highs. Inflation seems like it can only produce bad news. The potential impact of low inflation is a downside risk that seems to get little attention. Finally, the market is not cheap or expensive on a short/medium-term time frame. This makes a big move more challenging.

The environment for equity investors is more difficult now than it was three or six months ago. The S&P 500 can still move higher, but it has less support. It does not even have the benefit of low expectations.

The S&P 500 broke out to new highs in Q2 after it surpassed the peaks of 2000 and 2007. Maybe the S&P 500 will need to trade sideways and wait for more earnings growth before continuing into the brave new world of new highs.

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Source: The Game Has Changed: 4 Dynamics Impacting The S&P 500 In 2H 2013

Additional disclosure: I may trade any of the securities mentioned in this article at any time, including in the next 72 hours. I still have some short positions (through options) on other major indices, but not on the S&P 500.