There are some things we know for certain about the year ahead. The Winter Olympics will take place in Russia, Brazil will host the World Cup, the mid-term elections in the US will take place in November, and the Chicago Cubs will not win the World Series. There is no certainty, however, about the stock market outlook. There never is.
Conventional wisdom holds that the stock market is poised to have another good year as economic growth accelerates, earnings increase double-digits on a per share basis, long-term interest rates remain relatively low, and money rotates out of fixed income and commodities and into stocks.
That view sounds a lot like the view that prevailed in 2013. Our current expectation is that stock market return will be positive - but modest - in 2014. That view is predicated on the following factors:
- The S&P 500 has increased as much as 27% on EPS growth of 5-6%, which leaves us thinking that the market has pulled forward 2014 returns into 2013.
- The fear entering 2013 that so much can go wrong has been supplanted by a sense that everything will now go right. In other words, there is not as much room to climb the proverbial wall of worry.
- Current P/E multiples reflect record profit margins that will be more challenging to sustain
- Volatility will increase as the market transitions from the old normal of more quantitative easing to the new normal of less quantitative easing
- Since 1929 the average price return for the S&P 500 in the third year following a gain of 10% or more in each of the previous two years has been -1.25%. For the seven instances since 1929 in which there has been a third consecutive "up" year, the average gain has been 10.9%.
The Future Is Now
2011 was a funny year for the stock market. Why do we mention that now? For the most part, the performance in 2011 demonstrated that earnings did not drive the market. They supported the market but they did not drive the market. To wit, earnings for the S&P 500 rose 14% in 2011 and yet the S&P 500 was flat that year after gaining 23% in 2009 and 13% in 2010.
There was of course a good bit of drama in 2011 surrounding the eurozone debt crisis and the debt ceiling debacle that ultimately invited a 20% correction in the S&P 500 and a shocking downgrade of the AAA debt rating by Standard and Poor's. With that in mind, a flat year wasn't so bad.
We bring this up because 2012 ended up being a pretty good year for the S&P 500. It increased 13% even though earnings only increased by 6%. The double-digit gain in the S&P 500 could be justified, however, as pricing in the strong earnings growth for 2011 that wasn't priced in when everyone was fixated on scary-sounding macro headlines.
Today, the tables have been turned. Earnings growth hasn't been all that great in 2013, but the stock market's performance has been outstanding.
The favorable resolution of scary-sounding macro headlines and the Fed's liquidity support have had a whole lot to do with that. The latter in particular has driven speculative buying interest in the stock market, but it has also left many participants convinced that economic growth will accelerate and that earnings growth will pick up noticeably in 2014 as a result.
According to FactSet, earnings are expected to increase 11% in calendar year 2014. That expectation has overshadowed the low earnings growth in 2013. It is our belief that it has been largely discounted in stock prices already.
What Could Go Wrong?
The fiscal cliff and worst-case recession scenario talked about at the end of 2012? Didn't happen. A tapering of the Fed's asset purchase program by Labor Day? Didn't happen. Larry Summers nominated to be Fed chairman? Didn't happen. A US-led military strike against Syria? Didn't happen. A debt default by the US? Didn't happen. A hard economic landing in China? Didn't happen.
Basically, if there was something ominous on the market's radar screen in 2013, it didn't happen.
An interest rate cut by the ECB? It happened. An interest rate cut by the Reserve Bank of Australia? It happened. More stimulus in Japan? It happened.
Leading central banks effectively maintained an "all-in" disposition, diplomatic efforts to defuse geopolitical tension were successful, and politics, while certainly disruptive at times, resulted in kick-the-can palliatives for market participants.
In brief, because nothing went truly bad for the stock market in 2013, there is now an abiding sense that nothing will go wrong in 2014 given the understanding that the worst appears to be over for the eurozone, labor market conditions in the US are improving, the Fed has basically affirmed that policy rates will remain highly accommodative for a considerable time after it ends its asset purchase program, a budget framework is in place to avoid a government shutdown, and consumer confidence is on the mend.
It is nice to know that the market has a sunny-side up disposition after building and climbing a wall of worry for so long, yet it seems to have an equally high sense of complacency which can be a risk in and of itself if bad things happen unexpectedly.
Valuation Is "Full"
Pick your P/E multiple. They're all above historical averages and have been bolstered by record profit margins that will likely be difficult to sustain as interest rates and labor costs increase.
- The Shiller P/E ratio or "CAPE" ratio, which is based on average inflation-adjusted earnings from the previous 10 years, is 25.0 versus a mean of 16.5.
- The trailing 12-month P/E ratio, using operating earnings, is 16.1 versus a 10-year average of 15.7, according to FactSet
- The forward 12-month P/E ratio, using operating earnings, is 15.0 versus a 10-year average of 14.0, according to FactSet
It is in this light that many pundits suggest the market's valuation is "full."
The multiple expansion has been aided by the Fed's policy support as well as inflation rates and long-term interest rates that are well below their long-term averages. However, if economic activity picks up in 2014, as many economists expect, inflation rates and interest rates should be moving higher and the Fed's policy support will be dialed back.
Those factors would be restrictive for multiple expansion unless earnings growth turns out to be much stronger than expected.
A Tapering, Then What
The writing is on the wall in the reduced budget deficit and improved labor market conditions that the Fed is likely to take a step down with its asset purchases. It is possible the Fed could do so as early as next week, yet the majority of primary dealers think the first tapering announcement will wait until either the January or March FOMC meeting (the latter will mark Janet Yellen's first meeting as chairman).
The timing is unknown, as is the market's ultimate reaction to a tapering decision.
If one accepts the view, as we do, that the stock market has ridden the QE wave of policy support to record highs, it is logical to think it will experience some indigestion when those asset purchases start to get dialed back. Just how much indigestion it experiences will hinge in large part on how the market feels about economic conditions at the time a tapering announcement is made, the path and velocity of long-term rates after a tapering announcement is made, and/or the market's belief in the Fed's forward guidance.
The Fed has been making a concerted effort to assure the market that a tapering is not a tightening and that the fed funds rate is going to remain extraordinarily low for quite some time after the asset purchase program ends. We would have to concede that the Fed has been successful with that communication judging by the fact that the S&P 500 rose to a record high as the data, and the case for a tapering, got stronger.
When the reality of the tapering hits, though, the reaction in the Treasury market is apt to be a dictating factor for the performance of the stock market.
This Time Is A Different Time
It is unusual for the S&P 500 to gain 10% or more for three consecutive years. Ironically, it has happened only three times since 1929: 1942-1944, 1949-1951, and 1995-1997.
Will this time be different? We don't know. We do know, however, that it is a different time. The Fed in its history has never provided the type of artificial price support that it has over the last five years and managing the exit process will be no small task.
And that's just the task at hand for the Fed, not to mention the ECB, the Bank of Japan, the Bank of England, and so on. To be sure, coordinated easing has a much more hopeful ring to it than does either coordinated, or uncoordinated, tightening.
We digress, but the management of monetary policy will loom large again in 2014 and will have attendant consequences for developed and developing markets alike given the residual impact on currencies and trade.
What It All Means
In our estimation, the spoilers with the most potential to interfere with another year of positive returns would be a spike in long-term interest rates and/or a geopolitical event.
There will be another debt ceiling debate, but with the mid-term elections in November, our assumption is that another concession will be made since neither party will want to be looked at in front of those elections as being responsible for driving the US into a default situation. To say the least, the market would find great fault with a default scenario.
We aren't going to use the tired phrase of saying we are "cautiously optimistic" about the stock market outlook. What we have is a practical view that is seeded by these fundamental factors:
- Earnings growth, now projected to be 11%, will probably be revised lower but still remain positive
- Real GDP growth should be about 2.5%
- Overall CPI will stay below 2.0%
- Long-term interest rates will press higher gradually, but not sky past 3.50%
An expected return of 6-7%, which takes into account a dividend yield of 2.0%, is a reasonable forecast and is fairly consistent with the average return of 7.1% since 1929.
In considering the year ahead, an improving economic backdrop typically plays to the advantage of cyclical sectors and growth stocks, yet it would be prudent to maintain some exposure to the less volatile countercyclical sectors given the uncertainty associated with the market's reaction to the Fed tapering its asset purchase program.
Our thinking is that the easy-money QE trade is over. In all likelihood, 2014 will be the year when there is a transition from the old normal of more QE to the new normal of less QE. How that impacts the stock market remains to be seen, yet less liquidity could provide some relative advantage to large-cap stocks, which have underperformed both small-cap and mid-cap stocks during the QE rally and for the better part of the last nine years.
Our market outlook is not fixed. Things happen and our outlook could change. That is the nature of a living, breathing, and psychological organism like the stock market. The Big Picture column, which we update weekly, will provide economic and investment insight along the way to our quarterly Market View update.