Heading into 2014, even perma-bears were growling bullish forecasts. That always makes us nervous; when everyone agrees something is happening in the market, count on the opposite to happen. The stock market has had a rough opening month and a half, but uncertainty has now displaced bearish conviction. Stocks suffered their worst single-session loss since June 2013 and their best two-day rally since October - all in the same week.
While is hard to know whether bulls or bears are in charge, the economic and earnings backdrop remains positive. As we do every month, we assess what is going in the economy and in the markets for clues as to the stock market's direction going forward.
The Economy, Interest Rates, and Earnings
In retrospect, 2013 was clearly a year of economic acceleration. U.S. GDP growth averaged a healthy 2.7% across the four quarters of 2013, a meaningful step-up from average GDP growth in the 1.6% range for both 2011 and 2012. Reflecting 4.1% GDP growth in 3Q13 and 3.2% in 4Q13, GDP growth in the second half of 2013 averaged 3.7%.
While it is true that 4Q13 growth backed off from 3Q13, that third quarter performance was built on inventory accumulation. Figuring that was not a sustainable trend, many economists modeled a sharp come-down for 4Q13 GDP, as low as 1%, as they expected inventory contraction to counter any growth in the economy.
Instead, the domestic economy experienced healthy demand growth almost across the board during 4Q13. Growth was particularly driven by personal consumption expenditures, which advanced 3.3% in 4Q13 after rising at a 2.0% pace in the third quarter. Both durable and non-durable consumer goods rose in mid-single-digits, with tepid services activity partly blunting overall consumer spending.
Non-residential fixed investment, a proxy for capital spending, rose 3.8% in 4Q after the inventory-driven gain of 4.8% in 3Q13. Technology spending in 4Q recovered from a weak 3Q13. Exports were particularly healthy, rising 11.4% in 4Q from 3.9% growth in 3Q; and imports grew less than 1%. Not every aspect of the economy was strong, though. Investment in housing fell 10 percentage points from 3Q. During 4Q, federal government spending declined about 12%, in the seasonally slack calendar 4Q after the government's fiscal year ends in calendar 3Q. That double-digit decline in federal government spending, one could argue, continues to obscure real strength in the private economy from many still-skeptical investors.
Looking forward, we believe the U.S. economy can expand at an average 3%-3.5% rate in 2014, again driven by the consumer, exports and better housing growth. We expect growth to be driven by continued consumer spending on homes and vehicles as well as essentials and services. We look growing export demand as global GDP accelerates to 3.5% in 2014. We are hoping for stabilization in public sector spending. Depending on these factors, and particularly the health of our major trading partners and the trend in public sector spending, we could see 2014 GDP growth coming in toward the high end of our forecast.
Assuming we are correct and the economy is accelerating, when will the Fed take the next step and increase the federal funds rate? Before handing off the reins to Janet Yellen, former Fed Chairman Ben Bernanke provided several clues. Remember that when the Fed launched Quantitative Easing, it targeted a 6.5% unemployment rate as the point at which QE would no longer be necessary and the Fed would begin to consider raising rates.
But in prior testimony, former Fed Chairman Bernanke indicated that the central bank would be in no hurry to raise rates once the asset purchasing program was over. We interpret that to mean the Fed will wait at least six months after its final bond purchase before beginning to raise rates. Mr. Bernanke also said that the Fed would not be inclined to raise rates unless inflation expectations were running 50 basis points above their target 2.0%. So another condition is an inflation rate of 2.5%. Almost every measure of inflation is at least 50-100 basis points below that level currently. Even that 6.5% unemployment rate sends an ambiguous signal so long as the labor force participation rate continues to slip and nonfarm payrolls growth shows flagging momentum. In summary, we do not anticipate any change in the Fed's discount rate before 2015.
Investors scared out of stocks this year have been shifting into fixed income. Recent economic data has been lukewarm, further contributing to the flight out of equities. Even our bullish faith was shaken somewhat by two consecutive months of less-than-stellar nonfarm payroll reports. The frigid winter weather slamming most of the nation likely is impacting jobs growth and overall business activity.
While yields have skidded lower, however, there are signs that the rally in bonds may be cresting. The 10-year yield, which moved from 3.0% at year end to a low of 2.6% at the end of January, has added about 10 basis points and at mid-February was just under 2.7%. If you chart the 10-year yield, the first thing you notice is that yields remain in a pattern of rising highs and higher lows. The recent bounce back in yields is the market's way of saying that it is premature to assume the recovery is off-track.
Also worth remembering is that bond investors face a steady drumbeat of tapering from the Yellen Fed. The new Fed Chairman's February 11 testimony before Congress reinforced the Fed's commitment to continue tapering Treasury purchases by $10 billion per month. Our outlook for rising rates during 2014 is essentially unchanged. We continue to regard stocks as attractively valued and bonds as overpriced, particularly after their recent run higher.
We have shaved half-buck off our 2013 EPS forecast, bringing it to $10.50 from an earlier $111 That said, 4Q13 is shaping up as a solid quarter of 10%-12% growth. Once again, the current quarterly reporting season is turning out better than the consensus forecast. More and more companies provide explicit guidance, and why wouldn't they? CFOs have learned that by guiding a few cents below their actual expectations, their stock price tends to hold up better when they "surprise" the Street by reporting results a few cents ahead of consensus.
Argus Chief Investment Strategist Peter Canelo's current 2014 S&P 500 earnings forecast of $121.50 assumes 9.9% growth in earnings this year. After two years of 5% EPS growth, several things must fall into place for the S&P 500 to hit our EPS growth target this year.
Emerging economies, which provide up to one-quarter of S&P 500 earnings, have been hurt by the end of easy money as the Fed moves from QE accommodation to tapering and, eventually, to rate hikes. Even more than the global tightening in monetary policy, the chief disruption in Asia has been the orchestrated collapse in the yen. We now believe the worst of the yen's decline is behind. That could provide needed stability for emerging economies to restart growth.
Europe has delivered some encouraging signs, avoiding recession and even growing GDP in select areas such Germany and Scandinavia. In the U.S., investors need to see that December-January weakness in nonfarm payrolls was an aberration and that consumer confidence is growing.
After two years of mid-single-digit growth, high single digit or possibly low double digit EPS growth in 2014 would be welcome. EPS growth is required to keep valuation multiples from becoming too "stretched." Rising earnings are required to drive further stock gains in 2014, particularly in a bull market that is rapidly approaching five years old.
Domestic and Global Markets
During 2013, all major equity indexes appreciated in the upper 20s to low 30s on a percentage basis, and bonds declined. But that's just a memory now. The Lehman Bond index, slammed in 2013, is in positive territory; as of 2/18/14, it was up 1.5% YTD. Most indexes are down a few percentage points year to date. Just in the past week, however, Nasdaq has swung to positive for 2014 and is now up 1.8%.
We have seen some notable reversals within the indexes. For all of 2013, Value outperformed growth. This year, we have seen growth (+0.6%) take an approximately one percentage point lead over value (-0.5%). One surprising statistic: the DJIA, the bluest of blue chip indexes, is down 100 points more than the S&P 500. Normally in a trending market, whether up or down, the DJIA has the most restrained performance as investors either shelter in the Dow in down markets or buy more risk away from the Dow in up markets. The DJIA's downside leadership this year reflects an absence of utilities, which is a leading sector year to date.
After a strong 2013, U.S. stock market leadership has reversed from economically sensitive and risk-on sectors to defensive sectors. On a month over month basis, we can see that sector weights have shaded slightly. Year over year, the themes of risk-on leadership is still shaping the sector weightings.
Year to date, Utilities are clearly in the lead with a 6% gain. That is providing some investors with shades of 2011, when Utilities were the unlikely full-year winner. That was a year in which investment in utilities was driven by plunging bond rates. If utilities thrive this year or even match the broad market, it will be because of strong operating fundamentals matched with investors' ongoing need for current income. The market's early-year defensive swing has bypassed Consumer Staples; besides Utilities, much of the defensive momentum is in Healthcare, which is the year's second best sector (+5.0%).
The worst performing sectors year to date include consumer discretionary (-2.4%), telecom services (-3.8%), consumer staples (-2.8%) and energy (-3.9%).
After several years of leadership, Consumer Discretionary is being hurt by the two subpar payrolls reports; moderation in vehicle sales; and weather impacted housing activity, or rather inactivity. Both Consumer Discretionary and Consumer Staples are losing too many shopping days to Old Man Winter. The decline in Consumer Staples' weighting is notable; it has now slipped below 10% of S&P 500 weight, putting it toward the low end of its historical 9%-13% weighting band. We are not looking for any quick recovery in this sector as consumer food preferences continue to fragment.
It will be interesting to see where leadership is three or six months from now. If leadership continues to favor defensive groups, that might dash our thesis of double-digit growth from the stock market and instead suggest a year of middling gains.
The lag in Energy seems puzzling, as natural gas prices skyrocket amid persistent frigid temperatures. Energy may be winning this winter's battle, but too many investors believe Energy is losing the war: too much supply coming online from the various shale formations, and too little demand growth amid the relentless push for more efficient vehicles, home heating systems, and the like.
We have all heard about the fiasco in emerging markets. Interestingly, the single worst performing international market in 2014 is Japan, hardly an emerging name. This year, investors are mainly cashing out after 2013's lights-out gain of 57%, and so Japan is down over 9%.
But the BRIC nations are bleeding, down an average 5.2% year to date. The Euro zone is doing better than the global market overall, and we regard recovery in Europe as essential to our domestic GDP growth forecast for 2014. Other significant trading partners are down, including a 4.6% pullback for Mexico. But our neighbor to the North is in positive territory; Canada is up 3.5% year to date. That has to be good news for the basic materials sectors and for gold bugs in particular. In fact, now that the same equity perma-bears that capitulated on stocks have turned bearish on gold, the yellow metal has been trending higher for two weeks - reminding us once again that when everyone agrees something is happening in the market, count on the opposite to happen.