The year of 2014 did not start that nicely for the stock market, especially compared to the beginning of the years of 2012 and 2013. By the end of 2011, the market was full of opportunities where many great companies were trading at single-digit P/Es or low double-digit P/Es excluding cash, and the anticipation and the announcement of QE triggered a massive rally that lasted 2 years. Now that the Fed is tapering its bond buying program, the richly-valued market is finding its way down in the start of 2014.
Don't get me wrong, I am not bearish on the market. If you check my past articles, you'll see that I am generally more bullish than bearish. On the other hand, you have to admit that in the absence of a QE, 2014's stock market performance will be a completely different one than what we've seen in 2012 and 2013. In the previous two years, we had a combination of QE-to-the-moon with cheap valuations and now we might have not-so-much-QE with rich valuations, which gives us a completely different scenario, and while shorting the market might not be a good idea, being cautious is highly warranted for the longs.
The last two years, the market rallied no matter what. Even when we would get bad news or bad economic indicators, the market still continued to rally relentlessly, and, let's admit it, we took it for granted. If we got bad numbers for unemployment figures, the market brushed it off and took it as "more QE!" and continued to rally. The market was getting addicted to the QE badly and now it fears that QE might be shrinking soon until it completely goes away.
In the last few years, the US economy recovered nicely almost to the levels prior to the recession if we look at the housing market and car sales. On the other hand, the unemployment situation still looks bad. Job creation isn't even able to keep up with the population growth and most of the drop in the unemployment rate came from people dropping out of the workforce rather than people actually finding jobs. Labor participation rate in the US is at 62.8% which is below where it was at the peak of the recession in 2009 (65.7%). There are 155 million people in the civilian labor force, which is the same as it was during the peak of the recession (even though the US population grew by several millions since then).
For the foreseeable future, the US economy's growth will be in-line with the country's population growth but there might not be much beyond that. In Europe, the economy isn't shrinking anymore but it isn't growing much either. There is very little to celebrate there. In the developing markets, there is huge panic because liquidity might be a problem once the Fed ends its QE program. In the last few years, so much excess capital made its way to economies like Brazil and Turkey, who ended up investing that money into construction projects rather than building a sustainable manufacturing base.
During the last 2 years, many stocks rallied because they were too cheap to resist; however, many other stocks rallied simply because they wanted to rally. In fact, those cheap stocks that deserved to rally the most ended up rallying the least, while the stocks with the highest valuations rallied the hardest. We started to witness the "Tech Bubble 2.0" during this period where companies like Yelp (NYSE:YELP), Twitter (NYSE:TWTR), LinkedIn (NYSE:LNKD) and Pandora (NYSE:P) reached ridiculous valuations even though some of those companies might never become profitable. A lot of hype, hope and dreams were built into some of these stocks where many years of future growth that might or might not happen was already baked in the price.
Towards the end of 2013, it was getting increasingly difficult to find any stocks we would consider to be cheap based on traditional metrics. There were some really cheap stocks but they were rare and far between compared to end of 2011 when you could pick any 4-5 blue chip stocks and most likely see your portfolio in solidly green for the next two years. In the absence of a QE, companies will have to prove to the public that they can grow and they can do it profitably so.
Since the recession of 2008, many companies were able to grow their net earnings much faster than their revenues because companies achieved significant margin expansion by reducing costs. The problem is, you can cut costs only so much before your revenue growth starts suffering. There is no model where one company can cut its costs to the moon to achieve infinite growth. All the cost cutting gave companies historically high margins that may or may not be sustainable, but it hurt the job growth prospects and many people are skeptical about whether we will see significant revenue growth in the blue chip stocks anytime soon.
Through mergers, acquisitions and consolidation, many blue chip companies became so big that there might not even be that much room for them to grow anymore. Imagine companies like Coca Cola (NYSE:KO), Procter and Gamble (NYSE:PG) and GM (NYSE:GM) who have so much presence in the world that there are very few avenues of growth for them other than a global population growth. Many blue chip companies are guiding for single-digit growth moving forward.
Without excessive liquidity of QE, the market will have limited upside because the investors will want to see profitable growth before betting their money in anything. Many companies in the market are highly profitable but they don't see much of a growth; similarly, many companies see strong growth but they are not profitable. Keep in mind that none of the debt issues in Europe and the US are anywhere close to being solved. Even though the QE helped us put some of the debt-fears under the rug temporarily, these issues will make a comeback sooner or later. Does that mean the market will crash? Not necessarily, but it pays to be cautious. Most of Europe and the US are still buried under debt and they will be so for the foreseeable future.
If the market sees a correction, it's not necessarily a bad thing. A correction could provide many of us with opportunities to get our favorite stocks at cheap prices again. If the correction is too harsh, the Fed will be prompted to act on it and possible extend its "generous" money policies, even though this may not be so great in the long run. For the time being, the Fed created a stock market that is addicted to free liquidity and the only way to fix things might be to sustain some short-term pain be removing free money from the market at a slow but sure pace.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.